Wall Street Wants to Know: Where's Paul O'Neill?

The U.S. economy is grimacing as unemployment rises and corporate earnings fall faster than stock prices. So where is Paul O’Neill?

So far, the treasury secretary is trying to go along with a $100-billion congressional economic stimulus package, but on Wall Street not everyone is impressed. Momentum is growing for more serious measures, such as a capital gains tax cut that would raise returns on investment.

For many, it’s the only solution that will work. But getting that passed in Congress will take guts from Bush’s lieutenants such as O’Neill and Economic Adviser Larry Lindsey, who would have to take on class-warfare artists in the Democratic Party. So far, Wall Street isn’t seeing those guts, and the market is restless.

Around the Street it’s impossible to find anyone actually against a cut in the capital gains tax, at least as a long-term solution.

But since the 9/11 terror attacks, players don’t want to wait around for stimulus measures to take effect. One of the most outspoken proponents is Brian Wesbury, chief economist at Griffin, Kubik, Stephens and Thompson, Inc., in Chicago, who says the attacks worsened the U.S. economic picture. “This would be the single best tax cut to offset the damage done to the economy since 9/11,” he says.

“What that attack did, from the economic perspective, is raise risks and lower rewards. Investment risks are higher with war around the world. There’s Afghanistan, there’s Kashmir,” he says.

Congress’s fiscal stimulus package is not going to cut it, he says. “American Airlines is not going to buy a new airplane based on a revised depreciation schedule,” he says, referring to one stimulus package measure in Congress, explaining that it offered little reward.

Borrowing costs, on the other hand did fall after the Federal Reserve’s 10 rate cuts in the past year, but didn’t add much reward for taking investment risks.

“But if you cut the capital gains tax from 20% to 10%, some entrepreneur may start a new airline, because the rewards would be much higher. That is what the economy needs-more risk taking. Changing the depreciation schedule doesn’t do that,” Wesbury says.

Paul Kasriel, chief U.S. economist at the Northern Trust, in Chicago, views a capital gains cut as the antidote to conventional notions about economic stimulus packages, including the one before Congress, that zeroes in on ways to persuade reluctant consumers to spend.

‘Only Way to Grow’

“A capital gains tax cut is a fairly direct way to encourage savings and investment,” he says. “It lowers the tax on capital, so if you want people to save and invest, this is the only way to grow. If you just consume, it’s like eating your seed corn,” he says. The last thing we need is a consumer-spending spree, he says. “I think the capital gains tax cut would be the wise thing to do.”

Kasriel was particularly critical of proposals to increase spending as a supposed economic stimulus. “If you want to turn the U.S. economy into the Japanese economy, prevent the market adjustments now,” he said. “Japan kept businesses alive that should have perished years ago and kept people working in them who should have trained for other jobs. To get out of this cycle, you must accept your losses and go from there. If we interfere [with bad stimulus packages], we prolong the agony,” Kasriel says.

Mark Kahn, managing director of fixed income trading at Fleet Bank in Boston, points out that a capital gains tax cut will help battered equity investors and their 401Ks in particular. “The more astute investors know it’s great for stocks and their net return. With a capital gains tax cut, stocks become worth more-at any level-than they are now. If the government was taking 20%, and is now taking 10%, it’s worth more,” he said.

Kahn said there could be a stock sell-off on news of a tax cut, as doomsayers claim, but it would be marginal. “The reality is an increased return on investments, and stocks are almost always worth more 12 months later.”

The average S&P price ratio, he said, is still at 44.4 times earnings-despite the large drop in the stock market.

So what is the problem? Wesbury says the Bush Administration and its economic team have not acted with conviction about the need to get the economy moving through investment. “With this congressional stimulus package, we have ended up in a Keynesian quagmire,” he says. “I think the two key leaders on the economic policy are Paul O’Neill and Larry Lindsey. I would say both dropped the ball by not coming out forcefully enough on the economic equation. They should have pressured the President to get the administration back on the economic front two months ago. The President was brilliantly advised on the military side, but not brilliantly on the economic side, and the whole process was caught in a political battle,” Wesbury said.

Kahn thinks the administration’s biggest mistake has been to buy into the Democratic Party notion that if taxes are cut in one place, government spending must be cut equally elsewhere. “I think,” Kahn said, “the biggest obstacle in Congress is to see any potential tax cut in terms of static accounting.”


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