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Betting the ranch

STEPHEN FRIEDMAN HAS ALWAYS BEEN A TEAM PLAYER. AS A RISING STAR AT Goldman, Sachs & Co., then Wall Street's last major partnership, Friedman excelled in a culture that emphasized group effort on behalf of clients rather than individual achievement. He embodied that ethos in the early '90s by serving as co-chairman of the firm with Robert Rubin, forming a seamless partnership that was marked by professional camaraderie, not personal rivalry. Subordinates knew they could go to either one for a decision without provoking a feud.

"They used to say, 'If you tell one of us, you've told both of us,'" says Gary Gensler, who was recruited by Friedman to Goldman's merger advisory team and who later served in the U.S. Treasury under Rubin.

Today Friedman is heading the economic team of his most important client ever, U.S. President George W. Bush. As head of the National Economic Council, Friedman is the chief economic adviser to a president who in a bold bid to jump-start the economy has just signed his third major tax cut in as many years, at a time of record -- and rising -- federal budget deficits. It might seem like a surprising role for a man whose only previous public economic policy position was serving as a director of the Concord Coalition, a lobbying group that advocates fiscal discipline and criticized this year's tax cut.

It is all the more striking because Rubin held the same job in the Clinton administration and used it to advocate deficit reduction as the key to fostering growth. But true to his nature as a team player, Friedman is an enthusiastic supporter of the president's policies who has coordinated a united effort to promote the tax cuts and inspire confidence among consumers and businesses.

"I looked at where we were at the time he asked me to come here, and I said, 'This economy needs major stimulus,'" the 65-year-old Friedman says in a recent -- and rare -- on-the-record interview with Institutional Investor in his West Wing office. "I happen to be very comfortable with the economic plan. I wouldn't have wanted to come if I wasn't."

Friedman was appointed by Bush last December, along with Treasury Secretary John Snow, another former Concord Coalition supporter, to restore discipline to the president's economic team. As pragmatic, moderate Republicans with records of opposing deficits, both men were unusual choices to serve in such an ideologically driven administration. Indeed, some of the president's staunchest conservative supporters opposed the appointments. But over the past nine months, the two men have fulfilled Bush's expectations. Unlike their predecessors, Lawrence Lindsey and Paul O'Neill, whose erratic comments spooked financial markets and sometimes contradicted administration policy, Friedman and Snow have formed an effective team to promote Bush's tax-cutting agenda. With Friedman playing a behind-the-scenes role at the White House and Snow working Capitol Hill, the president won congressional approval of a $350 billion, five-year tax cut in May.

Now comes the hard part -- making sure the package delivers strong economic growth and employment gains. Normally, such a big fiscal stimulus, combined with the aggressive interest rate cuts by the Federal Reserve Board over the past two and a half years, would have ensured a vigorous recovery. But the nature of the current slump -- an investment-led downturn exacerbated by the collapse of the high-technology stock bubble -- has resisted conventional policy remedies, while the burgeoning deficit has raised doubts about the sustainability of the administration's fiscal strategy, a concern underscored by the recent surge in Treasury bond yields.

The whole world is watching. Japan's economy remains fragile and Europe is teetering on the verge of another deep slump -- Germany and Italy actually slipped back into recession in the second quarter. The global economy needs a strong U.S. rebound to regain its health.

If Bush's gamble pays off, the tax cuts will spark a surge of spending by consumers and business, transforming today's jobless recovery into a job-creating economic dynamo that reinvigorates U.S. growth and putting the global economy back on track. In turn, Bush would be all but guaranteed reelection in 2004.

But should Bush's plan falter, burgeoning deficits would put upward pressure on interest rates, choking off credit; instead of expanding, companies would continue to focus on cost-cutting and worried consumers might reduce their spending. The economy could even slide into a Japanese-style deflationary spiral of hesitant growth, ballooning debt and falling prices.

With the U.S. economy nosediving as he took office in January 2001, Bush offered a remedy to cheer the hearts of many American taxpayers: a record $1.35 trillion, ten-year tax cut. The massive fiscal stimulus helped make the recession one of the shallowest in the postwar era, but it failed to spark a vigorous recovery. Twelve months later, with the economy struggling to overcome corporate governance scandals and fears of terrorism, Bush signed an emergency package of investment tax breaks and extended unemployment benefits. Again the economy's response was lethargic.

Now the administration's third tax cut is just starting to kick in. The Jobs and Growth Tax Relief Reconciliation Act will give taxpayers $52 billion in the second half of this year by accelerating some of the tax rate cuts in the 2001 law and increasing the tax credit for children. More radically, the plan slashes taxes on dividends and increases investment tax deductions, in an attempt to boost equity valuations and stimulate capital spending by risk-averse corporate executives. This one-two punch aims to keep U.S. consumer spending going strong until business regains enough confidence to begin expanding capacity, and payrolls, after a three-year slump.

Will the latest tax cut work any better than its predecessors? Bush and his economic team have been crisscrossing the country to promote the economic package and, they hope, revive the confidence of both consumers and businesses. "We believe strongly that the tax relief plan that was approved by Congress in '01, and most recently in '03, is going to have a very positive effect on economic growth and vitality," Bush said last month after meeting with Friedman, Snow and other economic advisers at his ranch in Crawford, Texas. Snow also expressed confidence that the tax cuts will "produce the desired results. So let it work is our view."

Friedman gives a similarly upbeat message. "Everyone I talk to, even those who are at the low end of the confidence spectrum, is quite a bit more confident than they were two months ago," he says. "There's a huge amount that has to do with psychology and animal spirits."

Recent economic data offer support for the administration's optimism. The economy grew at a 3.1 percent annual rate in the second quarter, up from 1.4 percent in the previous two quarters, thanks to strong consumer spending and surging defense outlays as the U.S. went to war in Iraq. Crucially, business investment also is showing signs of life: Spending on equipment and software rose at a rate of 8.1 percent in the quarter, the fastest pace in three years. The economy is still short of the 3.5 to 4 percent growth rate that's needed to soak up excess capacity and bring down unemployment. And unlike last year, when growth spurts quickly fizzled out, it needs to sustain that pace. But the administration predicts that growth will hit that level by the end of this year and remain strong.

The Bush economic strategy still faces several big risks, however. The massive July sell-off in the bond market caused long-term interest rates to spike, offsetting some of the Fed's aggressive cuts. If rates rise because of investors' optimism about the economic outlook -- which N. Gregory Mankiw, chairman of Bush's Council of Economic Advisers, insists is the case -- that's no bad thing. But many bond investors blame the Fed and its chairman, Alan Greenspan, for the big reversal (see box, page 78). The Fed ignited a major bond rally in May by signaling concern about the risk of deflation and suggesting the possibility of unconventional monetary policy measures such as purchases of Treasury bonds by the central bank. But in late June the Fed appeared to abandon the possibility of unconventional measures, triggering the huge rout in the bond market, which drove up long-term rates by more than 140 basis points in two months. The new rate levels, if maintained, would effectively halt the wave of mortgage refinancings that has fueled consumer spending in recent years.

The Fed itself appears divided about prospects for recovery. Directors of the Minneapolis, Philadelphia and Richmond, Virginia, Fed regional banks joined Robert Parry, head of the San Francisco Fed, in requesting a 50-basis-point rate reduction in June rather than the 25-basis-point cut that was agreed. The regional directors worried that the economic recovery "was gaining no momentum," the Fed's minutes state.

The rise in rates coincided with growing concern about the deficit. In July the administration raised its estimate for the federal budget deficit in the current fiscal year to $455 billion, compared with $304 billion just five months earlier. The ten-year budget outlook, which forecast a $5.6 trillion surplus when Bush entered office, now looks likely to put the deficit at well over $1 trillion -- and projections by the Congressional Budget Office say it could even exceed $5 trillion. Most worrying to the administration's critics is the fact that under current policies the U.S. will be running large deficits when the baby boom generation starts to retire in significant numbers later this decade, putting upward pressure on federal retirement and health spending. Bush's program of big tax cuts today is "a form of looting" from future generations, argues George Akerlof, an economics professor at the University of California, Berkeley, and winner of the 2001 Nobel Prize for economics.

The deterioration in the budget has brought the deficit to center stage of the nation's political debate. The contenders for the Democratic presidential nomination promise to repeal some or all of Bush's cuts, which they assert are part of an ideological agenda to cut taxes for the wealthy and shrink government by squeezing its revenue base.

"They have a political agenda more than an economic agenda," says Senator Jon Corzine, the New Jersey Democrat who succeeded Friedman as chairman of Goldman before running for public office. "I'd go see Karl Rove if you want to know what's going on with economic policy," he adds, referring to Bush's chief political adviser.

"It is immoral that this administration is willing to let the national debt mount up on the backs of our children and grandchildren to finance tax cuts for his friends and contributors," says Florida Senator Bob Graham, a Democratic presidential candidate who has led the calls for repealing the cuts. "George Bush is managing this economy the way his friend Ken Lay managed Enron. He's running it into the ground."

Even Greenspan, who gave crucial support for Bush's 2001 tax cut package, has stepped up warnings about the projected deficits. "There is no question that if you run substantial and excessive deficits over time, you are draining savings from the private sector and, other things being equal, you do clearly undercut the growth rate of the economy," he told the Senate Committee on Banking, Housing and Urban Affairs in July.

Administration officials have been forced to address concerns about the deficit even as they insist that economic growth and spending restraint will close the budget gap. Treasury Secretary Snow calls the deficit "worrisome" but "manageable." He says, "Sure, the deficit is bigger than it should be. We're not happy with it. How do you deal with the deficit? By growing government revenues and by controlling government expenditures. We're committed to seeing both of those things happen." So far, however, there's little evidence of that commitment. With the war in Iraq costing the Pentagon nearly $4 billion a month and Congress preparing to pass a Medicare prescription drug bill, supported by Bush, that is projected to cost at least $400 billion over ten years, there is a risk that the deficit will balloon further and that the government's borrowing needs will crowd out the private sector's.

"The Bush administration is doing some serious long-term damage to the fiscal health of the country," says William Dudley, chief U.S. economist at Goldman Sachs, which projects a ten-year deficit of $4.5 trillion. "If you do put up long-term deficits, you really are condemning the country to a slower growth path."

Bush's economic strategy is also exacerbating America's other great deficit, with potentially serious consequences for the dollar and the global economy. The U.S. current-account deficit is expected to hit a record of nearly $600 billion this year -- roughly 5.6 percent of GDP. And with the U.S. economy forecast to grow faster than Europe and Japan again next year, the deficit is almost sure to rise above 6 percent of GDP in the short term. So far the U.S. has been able to attract the global savings needed to finance the deficit, thanks to a lack of good investment alternatives in Europe and Japan and the willingness of China and Japan to accumulate massive dollar reserves rather than watch their currencies appreciate against the dollar. Indeed, hints of a strengthening U.S. economy have given the dollar a significant lift in recent weeks. But the more the current-account deficit grows, the greater the risk that foreigners will lose their appetite for U.S. securities, causing the dollar to drop and U.S. interest rates to rise. Many economists believe that the growing current-account deficit was a big factor behind the dollar's decline of 20 percent on a trade-weighted basis between January 2002 and June of this year.

Kenneth Rogoff, chief economist at the International Monetary Fund, says that the current-account deficit is due for a correction within three to five years, either as a result of faster growth overseas or a sharp slowdown in the U.S. "I view it as patently unsustainable," he says. The Fund, in its annual Article IV review of the U.S. economy, also delivered a blunt criticism of Bush's fiscal policy, warning that unrestrained budget deficits would "eventually crowd out investment and erode U.S. productivity growth." It urged the administration to set a clear target for balancing the budget, excluding Social Security surpluses, within five to ten years.

The administration has begun to focus on the current account indirectly by stepping up its efforts to stimulate global growth. Snow stepped into Europe's deficit debate during a July visit to London by endorsing French President Jacques Chirac's appeal for an easing of the 3 percent deficit limit for countries using the euro, saying that effective fiscal policy is necessary to boost growth. This rare expression of support for Chirac from an otherwise hostile administration speaks volumes about Bush's economic priorities. Meanwhile, Snow and John Taylor, the Treasury undersecretary for international affairs, have been talking to the U.S.'s trading partners about focusing the next Group of Eight meeting, which Bush will host next June in Sea Island, Georgia, on growth.

The idea is not to come up with a coordinated policy -- a strategy that met with mixed results in the late 1970s and mid-1980s -- but to encourage G-8 countries to do what's needed at home to foster growth.

"I can't think of anything more important for finance ministers to focus on," Snow said in London, where he met with Chancellor of the Exchequer Gordon Brown and German Finance Minister Hans Eichel. "The plain fact of the matter is, neither the EU nor Japan nor the U.S. is growing at rates that are appropriate for coming even close to the full potential of these economies. What it means is lower standards of living, less saving, lower long-term growth rates."

Snow's assertions were well received in Europe, but officials there question whether anything can be achieved without clear pro-growth policy objectives and peer pressure by the G-8 to encourage implementation. "Some more precision about what partners are supposed to do would be welcome," says Caio Koch-Weser, Germany's deputy Finance minister. David Mulford, the Credit Suisse First Boston International chairman and former Reagan administration Treasury undersecretary, contends that the Bush administration should be pursuing policy coordination within a revamped G-8 that includes China and one or two other major emerging-markets economies. But Mulford, who in the mid-1980s helped orchestrate the Plaza and Louvre accords, which sanctioned a sharp decline in the dollar and called on Europe and Japan to stimulate their economies, says the administration is ideologically disinclined to go that route.

"The U.S., and this administration, has not recognized the need for a global growth strategy," says Mulford. "But without a global growth strategy, who are you going to export to if your partners are growing by just half a percent to 1 percent a year?"

Much depends on whether the Bush economic strategy succeeds. If the tax cuts work, the economy should roar back to health by the end of this year, giving a strong boost to global growth and virtually sealing Bush's reelection in November 2004. If the tax cuts don't work and U.S. growth flags again, a weaker dollar would spread economic pain around the world. And U.S. military involvement in Iraq would look more and more like a case of imperial overstretch, British economic historian Niall Ferguson has written.

Administration officials don't deny that the economy faces risks, but they express confidence that they are on the right track. They insist that they are correct to pursue aggressive policies to counter a series of negative shocks to the economy: the September 11 attacks, corporate governance scandals, higher oil prices and geopolitical uncertainty leading up to the war in Iraq. The latest tax cut provides just the right mix of short-term consumer stimulus and long-term supply-side incentives to get the economy back to robust health, Friedman contends. In an interview he expressed confidence that the tax cuts would have the economy growing at a rate of at least 3.5 percent by the end of the year (see box, page 76). And it's a sign of the changing times that whereas Rubin saw the bond market as the key to economic growth (hence his focus on deficit reduction), Friedman places the accent on stock prices.

"One of the aspects that we've put a lot of attention on is the impact on the stock market," he says. "You can't prove what's cause and what's effect, but I'd rather be where we are, taking the position that, yes, it's had a material effect on the stock market, and it's helped with corporate dividend paying, corporate confidence. And that confidence barometer helps not only business, it helps consumers. The tax cut also put so much more money into people's hands. So with much higher real disposable income, I am hopeful of a virtuous cycle. The consumer will be spending more, and business will be further emboldened."

Private sector economists have been ratcheting up their growth forecasts lately, reflecting their belief that tax cuts and easy money from the Fed are bound to stimulate the economy. The Blue Chip Consensus of more than 40 leading economists predicts that the economy will grow at an average rate of 3.7 percent in the second half of this year and the first half of 2004. "You've got half a dozen major sources of stimulus," says C. Fred Bergsten, head of the Institute for International Economics and a Treasury official in the Carter and Reagan administrations. "If it does not produce a major growth spurt in the next year and a half, I think you've repealed the laws of economics."

But forecasts have been wrong before. Indeed, in the past three years, economists have repeatedly predicted a vigorous recovery only to be disappointed by reality. In July 2002, for example, the Fed forecast that the economy would grow by 3.5 to 4 percent in 2003; it reduced its projection to 3.25 to 3.5 percent in February of this year and then again to 2.5 percent to 2.75 percent in July.

For many economists and Fed officials, these downward revisions reflect the unique nature of this business cycle. Instead of a classic overheating, where growth puts upward pressure on inflation until the Fed slams on the monetary brakes, the current slump was caused by a sharp drop in business investment after the collapse of the high-tech equity bubble in 2000. Although monetary and fiscal stimuli are effective at boosting consumer spending, they have proven far less potent in getting business to lift investment at a time when capacity utilization is running at a low 73 percent.

"We haven't had much experience, perhaps none, in the postwar period of an investment-led slowdown," acknowledges Federal Reserve Board governor Donald Kohn in an interview with II. "It is a difficult cycle. Predicting how things will rebound is very hard."

Kohn believes that the combination of tax cuts and rate reductions by the Fed, which has slashed the federal funds rate by 550 basis points over the past two and a half years to a 45-year low of 1 percent, are breaking the economy out of its recent sluggish 2 percent growth range. He draws encouragement from the recent pickup in corporate merger activity and the firmness of the stock market despite recent accounting and corporate governance problems at HealthSouth Corp. and AOL Time Warner.

"The sense of gloom and the pervasive unwillingness to take risks seem to be lifting to a certain extent," Kohn says. But he cautions that the strength of the recovery remains in doubt. "That's what we're still trying to figure out."

The failure of monetary and fiscal stimuli to generate sustained recovery so far reflects two factors, according to Stephen Roach, chief economist at Morgan Stanley. There is no pent-up consumer demand to spark a surge in growth, because the consumer never stopped spending -- sales of new homes and automobiles are at or near record highs. And business investment remains subdued by the continuing excess of global capacity and a lack of pricing power. "Traditional policy always disappoints in postbubble economies that have gone to excess," says Roach. "That underscores the ultimate risk: A persistence of subpar growth in the current climate could take the U.S. economy further down the slippery slope toward outright deflation."

The longer that tax cuts and monetary easing fail to foster a sustained recovery, the more economists are tempted to draw parallels with that other postbubble economy -- Japan. "The real danger is that, as in 2001, the tax cuts will produce a temporary surge in demand accompanied by two to three quarters of higher growth followed by another relapse into lower growth," says John Makin, a director at hedge fund manager Caxton Associates and an economist at the American Enterprise Institute, a conservative think tank. "This scenario is distressingly similar to the Japanese scenario during the 1990s, when fiscal stimulus packages excited growth for a time but no sustainable recovery followed." Makin worries that the Fed's decision to reject unconventional policy measures runs the risk of limiting the economy to a below-trend growth rate of 2 to 2.5 percent.

"We don't really know if policy can prevent a Japan outcome or just delay it," says Goldman Sachs economist Dudley. "The real question is: Will the tax cuts flow through to employment growth and capital spending? I think the jury's out. We'll know in six months."

Bush is counting on his team to silence such doubts and instill confidence. In Snow he tapped the respected chief executive of transportation company CSX Corp. and a former head of the Business Roundtable, a lobbying group that represents 150 major corporations. As a former co-chairman of Goldman Sachs, Friedman delivers credibility on Wall Street -- an important commodity for an administration with massive, growing borrowing needs. The appointments reflect Bush's determination to win broad business support for the 2003 tax cut package and to coherently promote his economic agenda.

To many observers, including some of the president's staunchest conservative supporters, the two men were not immediately obvious choices. Snow, like Paul O'Neill, was a moderate Republican CEO with an Old Economy background. And whereas Lawrence Lindsey provided much of the intellectual firepower for the administration's supply-side tax cuts, Friedman was a former co-chairman of the Concord Coalition and a board member of the Brookings Institution, both of which criticized the Bush tax cuts. National Review magazine staged a last-minute campaign against his appointment, trumpeting on its Web site: "Warning to Bushies: DUMP Friedman! He's no tax cutter."

Over the past nine months, however, both men have demonstrated why Bush placed such faith in them. Where O'Neill was erratic, disparaging financial market traders and questioning the merits of a dividend tax cut just as the White House was agreeing to make it the centerpiece of its 2003 tax bill, Snow has been consistently on-message. He lobbied Congress aggressively this spring in support of the tax package, and since it passed he has been indefatigable in touring the country to promote the tax cuts and boost confidence.

"Snow has been a star," says Stephen Moore, head of the Club for Growth, a conservative lobbying group close to the administration that advocates tax cuts and smaller government. "He's been a powerful, articulate promoter of the president's agenda."

Friedman, meanwhile, has been as discreet as his predecessor was loquacious. Lindsey, an architect of the 2001 and 2003 tax cuts, was the administration's chief public defender of the supply-side case for tax reductions. He drew the wrath of administration colleagues last fall, however, when he publicly estimated the cost of an Iraq war at about $200 billion (a figure that appears more accurate by the day). By contrast, Friedman considers himself an honest broker who prefers to manage economic policy behind the scenes. He models himself after his former Goldman co-chairman, Rubin, who avoided the limelight when he headed Clinton's National Economic Council.

"I think I'd lose efficacy if I was perceived as steering policy," Friedman says. "Everything important that happens in government has a lot of different strands and a lot of different departments involved. The job is to make sure we forge a consensus to present to the president, or to say, Here are the alternatives. He's a very decisive man."

Colleagues say that Friedman's low-key style is appreciated in the Bush White House, where loyalty to the president and verbal restraint are prized above all. "He's very self-effacing," says a former administration official. "He doesn't need to be in the spotlight. He gets the job done."

The only misstep from Bush's new economic team so far has come from Snow, who appeared to signal a shift in administration policy in June when he defined a strong dollar as one that resisted counterfeiting rather than one with a firm exchange rate. Many investors had already perceived the administration's stance to be one of benign neglect, and the dollar's nearly 20 percent decline in 2002 and early 2003 helped support U.S. growth at a time of weakness. But Snow's seemingly cavalier comment rattled markets and sent the dollar falling by more than 1 percent in a day. The decline prompted Bush to publicly reaffirm support for a strong dollar -- a rare intervention from him. For Snow, "it certainly cost him something to be upbraided in public by the president," says CSFB's Mulford.

Snow and Friedman lunch weekly at the White House with Commerce Secretary Don Evans; Joshua Bolten, another former Goldman executive, who recently moved from being Bush's deputy chief of staff to head the Office of Management and Budget; and Council of Economic Advisers chairman Mankiw. Unlike O'Neill and Lindsey, who frequently seemed to speak at cross-purposes in public, each member of Bush's current economic team has a clear role to play and sticks to it. Snow and Evans are the public voices of economic policy and toured the country this summer to talk up the latest tax cuts; Bolten prepares the administration's budget projections; Mankiw is the president's chief economist; and Friedman coordinates the advice that reaches Bush's ear. "This group functions as a team," says the former administration official. "They don't give three different stories in public on a given day."

For all its prowess in promoting Bush's agenda, the current economic team has done little to shape policy. They inherited tax cut proposals drawn up largely by Lindsey and Glenn Hubbard, who preceded Mankiw as head of the Council of Economic Advisers. Both the 2001 and 2003 tax cuts reflect a supply-side belief that reductions in marginal tax rates and on taxes on capital gains and dividends generate faster growth by providing incentives to work and save more. They also concentrate the bulk of tax relief among high-income taxpayers and shareholders, who are the administration's strongest supporters. That fact, combined with the imposition of tariffs on steel imports and a big increase in farm aid, which conservative economists deplored but which played well with voters in key states, suggests to some that administration policy is driven as much by electoral considerations as economic ones.

The first Bush tax cut was one of the most timely fiscal packages in memory. By cutting the lowest tax bracket from 15 percent to 10 percent and increasing the child tax credit, the measure pumped $57 billion into the economy in 2001 and $69 billion in 2002. The money kicked in just as the economy was hitting bottom after confidence was battered by the collapse of the tech stock bubble and the September 11 attacks. The Council of Economic Advisers estimated that without the reductions the 2001 recession would have been more than twice as severe as it was and the 2002 recovery would have been weaker. Initially, the package had only a modest impact on the deficit: The bulk of the cuts, including the reduction in the top tax rate from 39.6 to 35 percent, were due to be phased in over ten years. With large budget surpluses projected at that time, the administration argued successfully that it was only returning some of the surplus to taxpayers, a view that won significant bipartisan support.

The politics and the economics surrounding this year's tax cut, however, are dramatically different. Concerns about the mounting deficit prompted defections by two Republican senators, George Voinovich of Ohio and Olympia Snowe of Maine, forcing Bush to nearly halve the size of the package, to $350 billion from $674 billion. And the centerpiece -- a cut in the tax on dividend income from as much as 35 percent to 15 percent, as well as a reduction in capital gains taxes from 20 percent to 15 percent -- provoked heated controversy. Administration officials, who first wanted to completely eliminate the dividend tax, had touted the idea as a supply-side initiative that would boost the stock market and lower the cost of capital to companies. But as they worked for congressional approval this spring, they portrayed the tax cut as more of a stimulus for the weak economy. For some economists, this shift resembled the administration's justification of the war in Iraq, which initially focused on weapons of mass destruction and then switched to the goal of bringing peace and democracy to the Middle East.

"The tax cut strategy is just like the Iraq strategy," says the Institute for International Economics' Bergsten. "They start out with one rationale and end up with another."

Critics contend that the best way to stimulate the economy is to focus on temporary tax relief for people who are most likely to immediately spend the money. The Economic Policy Institute, a union-backed think tank, proposed a temporary reduction in payroll taxes, which would tilt the benefit of tax cuts more toward low-income taxpayers. It also called for an increase in federal aid to the states to ease their budget crises. Such a tax cut would be more likely to be spent in the short term, thereby boosting the economy, without worsening the deficit in the long term, the institute contended. By contrast, the Bush tax cut concentrated its benefits on high-income taxpayers. The richest 1 percent of taxpayers will see their aftertax incomes rise by 3.6 percent as a result of the 2003 tax cut, while the poorest 60 percent will see their incomes rise by 0.8 percent or less, according to the Tax Policy Center, a unit of the Urban Institute and the Brookings Institution. In a statement endorsed by Akerlof and nine other Nobel Prize winners, the Economic Policy Institute charged that the real aim of the Bush tax cut was "a permanent change in the tax structure and not the creation of jobs and growth in the near term."

For Friedman, however, the critics just don't get it. Taxpayers need to believe that tax cuts will be permanent if they are to spend more and work harder. That will provide more stimulus in the short term and create incentives for faster growth over the long haul. "People are just much less likely to spend $1,000 that they consider a one-shot windfall than if they look at it as something in their withholding taxes and regard as a permanent increase in their income stream," he says. "For things that will cause people to basically change their behavior, change their work habits, change their ways of doing business, you want permanent. We're very, very comfortable with the tax cut. It's working the way we wanted it to work."

Administration officials also are confident that the dividend tax cut will boost the economy by lifting stock market values. Mankiw estimates that the reduction will increase equity values by at least 5 percent; Friedman attributes a good portion of the recent market recovery to the dividend move. Simeon Hyman, an analyst at Deutsche Bank Securities, says a strong performance this year by high-yielding stocks -- stocks with dividend yields of 4 percent or above outperformed the Standard & Poor's 500 index by nearly 8 percent between December 2002 and June -- proves that Friedman is right. Companies also have begun to respond to the change, with Citigroup raising its quarterly dividend 75 percent, to 35 cents a share, in July. The tax cut "levels the playing field between dividends and share repurchases as a means to return capital to shareholders," explained Citigroup chairman Sanford Weill.

"It was just the right type of tax cut for what was needed," says David Malpass, chief global economist at Bear, Stearns & Co. and a former Treasury official in the Reagan and first Bush administrations. "You needed to encourage investment, and the best way to do that is to lower the tax on profit, on equity buildup. The benefits of the tax cuts compound because they lower the cost of capital." Belief in the dividend tax cut's direct impact is far from universal, however. Linking the recent rally to the tax cut is "pretty tenuous," says Paul McCulley, Fed watcher at fixed-income mutual fund family Pimco and manager of the firm's $4.5 billion short-term fund. After all, he notes, the start of the market rally coincided with the entry of U.S. troops into Baghdad.

Regardless of its true impact, the tax cut needs to overcome some stiff economic headwinds. The first is the reluctance of business to invest and hire. Though high-tech capital spending has picked up and M&A activity is showing signs of revival, most corporate executives continue to hunker down and focus on cost-cutting. That's why former Council of Economic Advisers head Hubbard doesn't expect to see growth reach a 3.5 to 4 percent pace before the first half of 2004, despite the administration's forecast that it will happen in the fourth quarter of this year. "Business people are more risk-averse than at any time in my memory," he says.

Then there's fiscal drag. The economic slowdown has pushed U.S. states into the red by a total of about $80 billion this year. Goldman Sachs economist Dudley estimates that states will cut spending or increase taxes by as much as $50 billion this year to close that gap -- an amount that roughly equals the stimulus from the Bush tax package.

Meanwhile, the recent rise in interest rates threatens to bring an abrupt halt to mortgage refinancings, a major boon to consumer spending in recent years. U.S. homeowners removed an estimated $96 billion in home equity in 2002 and $50 billion in the first half of 2003 by refinancing and taking out larger mortgages, according to the Federal Home Loan Mortgage Corp. The Council of Economic Advisers estimates that homeowners spent roughly half of their cash-outs, boosting economic growth by about 0.4 percentage point last year. However, the 140-basis-point surge in long-term rates between June and August alone, if maintained, could dry up the refinancing business. Refinancing applications plunged by 75 percent in July and August alone, according to the Mortgage Bankers Association of America.

"Low interest rates allowed everyone to turn their house into an ATM machine," says Pimco's McCulley. "The house as ATM machine is over, done, finished, kaput at this level."

The administration dismisses interest rate concerns as overblown. Far from constituting a threat to the recovery, the rise in rates largely reflects investors' optimism that recovery is under way, asserts Mankiw. Many Wall Street economists concur. Bear Stearns' Malpass says that rates are merely returning to normal levels after an unsustainable decline in May and June. He estimates that the U.S. Treasury, agency and corporate bond markets lost $380 billion in value between the mid-June peak and late July, while U.S. equity market capitalization increased by $1.8 trillion from its mid-March low. "We're confident that the economy and equity markets will prefer reflation to deflation," Malpass says.

Even if the administration's optimism is correct and the economy does get back on a solid growth track, the budget deficit is almost certain to remain a contentious political and economic issue. That's because the administration's own projections show a sizable deficit persisting later this decade, at a time when the leading edge of the baby boom generation will begin to retire, straining Social Security and Medicare. Under current rules, spending on those two programs is projected to rise from 8 percent of GDP today to 20 percent in 2075 -- more than today's entire federal budget.

The Office of Management and Budget's recent five-year forecast projected a deficit for this year of $455 billion, or 4.2 percent of GDP, rising to $475 billion in 2004 before declining gradually to $226 billion, or 1.7 percent of GDP, in 2008. The red ink totals $1.46 trillion for the period. It's likely to get worse after that. The Congressional Budget Office predicts a return to surplus in 2012, but that's only because it assumes that the main provisions of the 2001 and 2003 tax cuts will be allowed to expire, as they are scheduled to do between 2008 and 2011. These so-called sunset provisions were included partly to conceal the long-term cost of the cuts, but no one in the Bush administration, or among the Republicans on Capitol Hill, expects them to lapse. Extending the tax cuts will add a whopping $1.56 trillion to the deficit over the next decade, the CBO estimates.

"You would have the largest tax increase in the history of the world without a vote of Congress," says Republican Senator Charles Grassley of Iowa, who is chairman of the Senate Finance Committee. "If there's ever an example of taxation without representation, that's it."

On top of the revenue shortfall, government spending continues to rapidly expand. Total discretionary spending, which represents about 40 percent of the federal budget and includes defense, has been growing by 9 percent a year over the past three years. Bush's 2004 budget calls for reducing the growth of discretionary spending to 4 percent, but that appears to be unrealistic. The cost of the war in Iraq continues to run nearly $1 billion a week, the Department of Homeland Security is ramping up its budget to as much as $30 billion a year, and Congress is getting ready to spend at least $400 billion over ten years on a Medicare prescription drug bill. What worries even the president's supporters is that he has never flexed his muscles to restrain spending. Grassley bemoans the fact that Bush hasn't vetoed a single spending bill, adding, "It would help if he did."

The true budget outlook, therefore, is daunting. The CBO projects that the deficit will total $3.76 trillion over the next decade if the Bush tax cuts are made permanent, Congress passes a prescription drug bill and the alternative minimum tax is amended to prevent it from hitting middle-income families, a change the administration also endorses. And that forecast assumes discretionary spending rises only as fast as inflation, something that hasn't happened in years. Using a more realistic spending assumption, the deficit would total $5.15 trillion over ten years.

Obviously, the combination of tax cuts and unrestrained spending increases is not sustainable over the long haul. "Nobody's been willing to say what's going to get squeezed -- that's really the long-term deficit crisis," says C. Eugene Steuerle, a budget expert at the Urban Institute who helped design the 1986 Tax Reform Act as a senior Treasury official in the Reagan administration. Bush's critics say that the people who will be squeezed are future generations; they will have to pay for today's tax cuts with future tax increases or reductions in entitlement benefits.

"As Milton Friedman once put it, if you cut long-term taxes without cutting long-term spending, you aren't really reducing the tax burden at all. You're just pushing it off yourself and onto your kids," says Peter Peterson, the Blackstone Group chairman and Nixon administration Commerce secretary who heads the Concord Coalition. "I've got five kids and nine grandchildren. I'm extraordinarily uncomfortable at the moral level with what we're doing here."

Administration officials dismiss the deficit doom-mongers. They distinguish between the general government budget, which they contend is under control, and entitlement programs, which will need fundamental reform. Mankiw points out that this year's projected deficit of 4.2 percent of GDP is below the postwar peak of 6 percent back in 1983, after the Reagan tax cuts, and says that with growth forecast to accelerate, the deficit will shrink steadily and leave the national debt at about 40 percent of GDP by 2008, roughly the average level for the past 50 years.

"The deficit is very manageable," he says. "The real fiscal danger is the entitlement programs."

The administration is pushing for the Medicare prescription drug bill to create vigorous competition between the private companies that will manage drug benefits for retirees. Such competition should help to contain costs, Mankiw contends. "The system is going to look more free-market oriented."

Mankiw and Friedman also indicate that the administration will continue to try to get individuals to take more control of their retirement planning. In the 2000 presidential campaign, Bush proposed allowing employees to shift a portion of their Social Security benefits into personal retirement accounts. "I've heard him say a number of times that he thinks that one of the reasons he got elected was because he was willing to focus on that," Friedman says. "I can't predict his timing, but you will be hearing more about that from him."

Administration supporters also expect Bush to reintroduce proposals for lifetime savings accounts and retirement savings accounts, which would allow individuals to put aftertax dollars into savings accounts and make withdrawals tax-free. "It will be the centerpiece of the Republican Party's election stance next year," predicts Grover Norquist, head of Americans for Tax Reform, a lobbying group for tax cuts and smaller government with close ties to the administration.

For the administration's opponents, the prospect of such changes is all the more reason to oppose the Bush tax cuts. "This is a program to undermine Social Security and Medicare as we know it," says Democratic Senator Corzine. "I don't know how we will pay for things that the American people expect to be in the social safety net."

With the battle lines drawn over economic policy for the 2004 presidential election, everything depends on whether the long-awaited recovery finally arrives and sustains itself. If Bush's big tax-cutting bet pays off with vigorous growth, the president's reelection should be virtually assured, strengthening his hand to pursue entitlement reforms and scale down the size of government in a second term. If not, he may look to his economic advisers to provide new policy ideas rather than just salesmanship.

Given that possibility, even the administration's critics are happy that onetime deficit hawks like Friedman and Snow are in key positions. "I'm glad they're there," says Corzine. "If there's ever hope for a change in policy, it will be in quiet circles in the White House." 


It's a far cry from the high-technology splendor of a sprawling Wall Street corporate suite, but what Stephen Friedman's cramped West Wing office lacks in amenities it makes up for in access. It lies next to the office of Karl Rove, the president's powerful chief political adviser, and just a short stroll down the corridor from the Oval Office. At 65, Friedman still has the lean, athletic build of the championship wrestler he was at Cornell University in the late 1950s. Today he prefers to flex his muscles in private. Friedman, head of President Bush's National Economic Council, believes his job is to be a consensus-builder inside the White House and is content to let Treasury Secretary John Snow be the public face of the administration's economic policy. "Low key is good," he says. For all his discretion, though, he is a firm believer in the president's tax-cutting strategy. Friedman discusses that strategy and his optimistic outlook for the economy with Institutional Investor European Editor Tom Buerkle.

Institutional Investor: The Office of Management and Budget came out with the budget projections a few days ago, with a deficit of $455 billion this year, higher next year. Are those deficits a cause for concern?

Friedman: Deficits matter to the president and he has made it clear to all his advisers that they matter, and his advisers didn't need any persuading. The deficits are manageable. The real issue is looking at the size of the deficit relative to the size of the economy. Give or take, the debt is 37 percent of GDP. And we're spending about 8 or 9 cents of the budget dollar on debt service. Now I think comparable numbers in the middle of the last decade were 45 percent and 15 percent.

The president has been very clear. He wants to see this after next year on a path moving down. We think that will happen. But he's got his priorities. Fighting the war on terror and stimulating the economy were clearly higher priorities. And I don't know any economist who disputes that. I just don't know anyone who argues that in the kind of environment we're in, we shouldn't be having fiscal stimulus. When I look at the criticism we get, it doesn't tend to be, 'Gee, you stimulated the economy.' It tends to be either the class warfare thing -- it was tax cuts for the rich -- or you should have done something very temporary.

Well, everything we've looked at about temporary measures basically said it doesn't stimulate anywhere near as well as permanent. People are just much less likely to spend $1,000 that they consider a one-shot windfall than if they look at it as something in their withholding taxes and regard as a permanent increase in their income stream. For things that will cause people to basically change their behavior, change their work habits, change their ways of doing business, you want permanent [measures]. We're very, very comfortable with the tax cut. It's working the way we wanted it to work.

You were a member of the Concord Coalition, which is very focused on deficit reduction. And you're running the National Economic Council for an administration that has very significantly widened the deficit. Is there any inconsistency there?

No, zero. I think fiscal prudence over time is a tremendously important thing. I don't find anything inconsistent with what we're doing. You come out of the period that we're in, I don't know anyone who argues with stimulus. Down the road, for the entitlement programs -- Social Security and Medicare -- you're going to have to have modernization. You're going to have to have a lot of education for the public. You're going to have to have a lot of bipartisanship and a lot of reform.

The president was absolutely a leader in really focusing on Social Security, not just talking about it. I've heard him say a number of times that he thinks that one of the reasons he got elected was because he was willing to focus on that. I can't predict his timing, but you will be hearing more about that from him.

How do you explain the lack of economic confidence within the business community?

They've been hammered so. They came off these tremendous twin peaks of the stock market bubble and the capital investment bubble. It takes a long time to dig out from bubbles of that magnitude.

There's another theory, which I happen to believe and I think the Federal Reserve believes. Somewhere in the mid-'90s, we figured out how to start using all the computers and software we had been buying. You started to see sharp increases in productivity. But there was a reservoir of productivity improvements that really didn't get tapped in the late '90s. I just know from experience that when you're running all out in business and you're trying to service customers, you don't have the energy, the mind share, to divert fully to cost-cutting productivity improvements. When things slow down, it's very natural for managers to start saying, 'Well, we've got to cut costs.' If you're in a risk-averse mood, I think finding productivity improvements, which usually means head-count reductions, has been the safest thing for them to do.

Recent profit growth is welcome, but there's no top-line growth. Presumably, you need that if the economy's going to grow.

One of the important things of the president's tax cut is that it jump-starts this process. We've put a lot of attention on the impact on the stock market. You can't prove what's cause and what's effect, but I'd rather be where we are, taking the position that, yes, it has had a material effect on the stock market and it has helped with corporate dividend paying, corporate confidence. And that confidence barometer helps not only business, it helps consumers.

The tax cut also puts so much more money into people's hands. So with much higher real disposable income, I am hopeful that that circular argument will turn into a virtuous cycle. The consumer will be spending more, business will be further emboldened. You're already seeing capital expenditure improvement. You're seeing a consensus of north of 3.5 percent [growth] for the second half of this year, and some people are talking about 4 percent and above. There's enough slack in the system so that can happen without inflation. There's no need for the Fed to tighten.

Is this going to be a jobless recovery?

No. It will not be a jobless recovery, but there are lags.


Did Alan Greenspan cause this summer's massive bond market sell-off? The fact that major investors are even asking the question suggests that the Federal Reserve Board chairman has lost some of his once-unquestioned command of financial markets.

It has been a hallmark of Greenspan's 16-year tenure that the Fed has moved quickly and decisively to maintain noninflationary growth: promising to provide liquidity in the wake of the 1987 stock market crash and cutting interest rates after the Long-Term Capital Management debacle in 1998. But although the central bank has slashed the federal funds rate by 5.5 percentage points since January 2001, the economy has remained lethargic.

The economy's continued sluggishness prompted Greenspan to suggest last November that the Fed might employ unconventional policies -- such as buying long-term U.S. Treasury bonds -- to drive down interest rates and encourage growth. The idea was promoted and developed in several speeches by Ben Bernanke, the Princeton University monetary economist who joined the Fed's policymaking Federal Open Market Committee last year. After its May 6 FOMC meeting, the Fed for the first time distinguished between the prospects for growth, for which it said the upside and downside risks were roughly equal, and for inflation, for which it cited the risk of an "unwelcome substantial fall in inflation."

The statement triggered a surge in bond prices. Many investors assumed that the Fed was genuinely worried about the risk of deflation and might begin buying bonds soon. Greenspan propelled the rally on June 3 when, addressing a Berlin bankers' conference via satellite, he said that the potential consequences of deflation were so severe that the Fed might need to create a "firebreak" against that risk. On June 13 yields on the benchmark ten-year Treasury bond hit a 45-year low of 3.08 percent, down from 3.89 percent before the FOMC's May statement. But when the FOMC cut the federal funds rate by only 25 basis points at its June 25 meeting -- disappointing hopes for a cut of 50 -- the market reaction was bloody. Over the next two months, the ten-year yield surged by nearly 1.5 percentage points, to just over 4.5 percent, the highest level in a year, as investors discounted the odds of Fed bond purchases and began pricing in a recovery.

The surge in rates could derail President George W. Bush's hoped-for recovery and keep the economy stuck at a below-trend growth rate of about 2.5 percent, says John Makin, a director at hedge fund manager Caxton Associates. Lawrence Kudlow, who heads the forecasting firm Kudlow & Co., called the episode Greenspan's "bondland botch" and said the chairman should consider retiring. Others were only slightly less harsh.

"The Fed was either off its game or it was duplicitous" in talking down rates, says Paul McCulley, managing director at mutual fund family Pimco. Greenspan "was unambiguously fueling the Treasury market during that period as surely as he was [the equity market] when he was talking about the New Economy in 1999. What was he thinking? Don't walk into a frat house on a Friday night and say that you've got beer if you don't have any. The boys are going to be ticked."

Peter Hooper, chief U.S. economist at Deutsche Bank and a former Fed staff economist, believes that investors share much of the blame for getting carried away about the possibility of deflation, which the Fed had characterized as "minor." But Hooper criticizes the Fed for not acting sooner to rein in the rally. "The Fed kind of went along for the ride. You got the feeling that they weren't too displeased to see bond yields go below 3.5 percent. They didn't give any indication that they felt the bond market was going too far."

Federal Reserve officials concede that the central bank's communications haven't been perfect of late. The May 6 statement was intended to signal that although the economic outlook had improved, the Fed wouldn't tighten at the first sign of recovery because of an absence of inflationary pressure, officials say. But the nuance was lost on investors, who regarded the statement's reference to the risk of a substantial fall in inflation as a red-flag warning of deflation. "There are two important points that the statement of May 6 tried to communicate that didn't really come across," William Poole, president of the St. Louis Fed, acknowledged in an August speech.

Should the Fed have moved sooner to nip the bond rally? Ironically, Federal Reserve Board Governor Donald Kohn -- who published a paper at the height of the bond market rally arguing that the central bank's words could steer the market as effectively as its rate moves -- says the answer is no. "I was surprised by how far long-term rates went down," Kohn admits in an interview with Institutional Investor. "But we don't have targets for long-term rates. We don't say: 'If they go down by 50 basis points, that's too much.' This is not the kind of fine-tuning we can do."

Some analysts believe that the Fed got cold feet when it realized that buying Treasuries would be a radical policy departure with no clear exit strategy -- how could the Fed unwind Treasury positions without sending the market, and the economy, into free fall? Kohn acknowledges the difficulties. "The more we thought about it, the more different kinds of things came into play," he says. "But I don't think complications would get in the way of doing something unconventional if we felt it were needed."

For the near future, the odds that the Fed will have to buy Treasuries to stimulate the economy appear remote, but the central bank's vacillation on the issue has clearly damaged its credibility. "In a way, that was the last bubble -- this idea that the Fed can always make things right," says William Dudley, chief U.S. economist at Goldman, Sachs & Co.

For Greenspan, like President Bush, everything depends upon a vigorous economic recovery. "If there's no sign of it by September," says Makin, "the chairman is going to look like a dope, and Bernanke is going to look like the guy who should be calling the shots." -- T.B.









The U.S. may be the world's unrivaled superpower, but it's hardly omnipotent. Its rating inInstitutional Investor's latest semiannual Country Credit survey of sovereign credit analysts (see page 93) fell half a point on uncertainties about the wisdom of its fiscal stimulus plan and questions about its growing military involvement in troubled countries. Alongside its lengthy occupation of Iraq, the U.S. must cope with crises from Liberia to North Korea -- all of which will require time and resources. Some analysts worry, too, that the U.S. economy has matured so much "it cannot develop any more," says Toshihide Terada, joint general manager of the credit division at Aozora Bank in Tokyo. Yet, putting aside those substantial worries, the U.S. remains the gold standard of creditworthiness -- and its securities still are the safe haven when global crisis hits.