“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
— Mario Draghi, ECB president, July 26, 2012
hesitate to write this chapter. This book is about material constraints and how they force policymakers down the path of least resistance, not the path that they have chosen themselves. And yet, this chapter is about a constraint that, more often than not, behaves like an optional preference.
Constitutional and legal constraints ought to be meaningful because in law-abiding societies, the law is a strong constraint to the individual citizen. No one wants a parking ticket, to end up in jail, or to be arrested for tax evasion. As a result, most individuals take the path of least resistance and operate within the constraints of the law.
But in policymakers' hands, these constraints are malleable. They get around laws more often than investors realize. When it comes to this particular subset of constraints, they are meant to be broken, especially in a crisis. In both Europe and the US, recessionary economic constraints forced policymakers to manipulate the legal constraints – and sometimes even the constitutional ones.
During the 2008–2009 Great Recession, the US banking system faced a liquidity Armageddon. Because their balance sheet collateral was worthless, banks abruptly stopped lending to each other and the real economy. Because the banks knew precisely what horse manure was on the books, they assumed that their counterparts were full of it as well. To suspend reality and allow banks to extend and pretend, the US Financial Accounting Standards Board (FASB) amended rule FAS 157, known as the “mark-to-market” regulation. This amendment allowed the banks to determine the value of their own assets on balance sheets.1 Specifically, the ruling on April 2, 2009, allowed banks to assess the value of assets based on their own assumptions rather than on “observable inputs” (i.e., reality).2
Poof. In one fell swoop, the financial crisis was on its way to being mended!
European policymakers not only amended the rules but ignored the EU constitution altogether. Article 125 of the Lisbon Treaty (and Article 104b of the Maastricht Treaty) expressly forbade bailouts of EU member states. As such, the first fiscal backstop involved interstate loans, rather than assuming full liabilities. On May 9, 2010, Euro Area members created the EU's first de facto bailout mechanism: the European Financial Stability Facility (EFSF). It was framed as an off-the-books special purpose vehicle (SPV). Eventually, the EU approved constitutional changes that allowed for the establishment of the more permanent European Stability Mechanism (ESM). But, at the height of the crisis, policymakers did more than rewrite and bend the law — they broke it.
Investors and corporate executives often get hung up on legal and constitutional technicalities. Don't! The constitution is not a suicide pact that dictates the operation of a country. Most of the time, other constraints come first. If the political capital exists, the economic and financial implications are meaningful. If the geopolitical imperatives are overwhelming, then policymakers will scrap or rewrite the rules. Quickly.
I discussed the Euro Area crisis in Chapter 4 through the lens of political constraints. It also exemplifies how political constraints are more restrictive than constitutional and legal constraints. The crisis only resolved once policymakers convinced the markets that they were, indeed, willing to do “whatever it takes.” Setting up the EFSF was not enough. Only Mario Draghi was enough.
On July 26, 2012, Draghi uttered his famous line, “Whatever it takes.” He did qualify the phrase with “within our mandate,” giving a nod to the rules governing the ECB mandate. However, he also appended it with, “believe me, it will be enough.”3
Draghi clarified that the ECB would bend its mandate to the preservation of the euro. Compared to the strength of all other constraints pushing against the euro's failure, a flimsy legal mandate was most easily broken. In 2011, Draghi used the Securities Markets Program (SMP) to intervene in the Italian and Spanish bond markets because their dysfunction was making appropriate monetary policy, and thus price stability, impossible. Eventually, the technocrats at the ECB defined Draghi's “whatever it takes” through a program called the Outright Monetary Transactions (OMT). This was Draghi's “big bazooka” that the ECB never actually used.
When it comes to the ECB's economic Band-Aids, looking back at the Euro Area crisis from the thick of the COVID-19 pandemic is like looking back at medieval Europe from the twenty-first century. Draghi's successor, ECB President Christine Lagarde, is not just using a bazooka. She is throwing the kitchen sink, a clawfoot tub, and all sorts of other household appliances at the economy. Within days – not months or weeks – the ECB crossed any remaining lines that may have existed on use of unorthodox monetary policy. And with the Macron-Merkel consensus on a mutualized fiscal backdrop, the EU has crossed the ultimate red line.
Policymakers' ease in breaking legal constraints shows just how strong political, economic, and geopolitical constraints are. As long as there is geopolitical and political will along with logic for integration, European policymakers will do “whatever it takes” to preserve the Euro Area.
A constitutional lens of analysis does not always deal with laws to be ignored. Sometimes, extant laws push policymakers onto the path of least resistance. President Trump had an ambitious agenda in January 2017, from a comprehensive immigration overhaul to repealing Obamacare. However, with the Senate majority insufficient to break the legislative deadlock on most issues,4 he was forced to focus instead on foreign policy and trade in his first term.
My teammate Matt Gertken and I huddled after the November 2016 election to produce a forecast of Trump's presidency. As we went over his priorities and campaign promises one by one, we realized many would die in Congress, even a Congress controlled by his own party. At the time, the consensus view was that Congress, chock-full of pro-trade Republicans and Democrats, would check Trump's most aggressive threats on trade.
This view did not sit well with our reading of history. President Nixon had imposed an import tariff on essentially all imports when he closed the gold window in 1971. And Obama had used tariffs, selectively, from the first month of his presidency.
Early in 2017, many investors were unfamiliar with the lack of constraints on the president's actions concerning trade policy. Article I, Section 8, and Article II, Section 2, of the US Constitution give Congress the power to govern trade. However, starting in the 1930s, Congress delegated its own authority to the executive branch via a number of legislative acts.5
This series of laws enacted over the past century gave Trump enough latitude to impose tariffs. The Trade Act of 1974 allows the US president to impose tariffs on countries as an effort to correct unjustified foreign trade practices. President Trump used Section 301 of the act against China. The Trade Expansion Act of 1962 allows the president to impose tariffs for the sake of national security, and the Trump administration used Section 232 to raise tariffs on a number of importers, including American allies like Canada.
President Trump also has the authority to declare an emergency and invoke the Trading with the Enemy Act of 1917, which allows the president to regulate all commerce and seize foreign assets. President Nixon used that act to justify a 10% surcharge tariff on all imports in 1971. He cited the Korean War – which had been over for 19 years – as the emergency. Since the Korean state of emergency had never officially ended, Nixon used it as a reason to impose tariffs on all imports.
Because of Nixon's loose legal framework for the surcharge, Congress ended up passing the 1974 act. Much as the EU eventually passed constitutional changes that allowed the EFSF to be replaced by the ESM, the US Congress retroactively normalized Nixon's policy.
Matt produced a table that listed all of the legislative acts that give the US president authority over trade. We threw it in our chart pack and pounded the proverbial pavement with the argument that Trump had no constraints to pursue a trade war with China. When the April 2017 Mar-a-Lago summit put the trade war on hold, the naysayers criticized our view. However, investors bullish on the US–China relationship misunderstood the point.
The absence of a legal and legislative constraint to trade war was the risk. At Mar-a-Lago, Trump's preference for deal-making prevailed. But if that preference changed, there would be no constitutional or legal constraint standing in his way. Betting on preferences, therefore, was folly.
On the hierarchy of constraints, constitutional and legal issues take the bottom rung. If these are the fulcrum constraints of your forecast, you are probably wrong.7 A proper net assessment – a term I describe in Chapter 9 – never begins with a legal analysis. It begins with an understanding of the first-string constraints: political, economic, financial, and geopolitical. Only at the end do constitutional and legal matters come to the forefront. Like preferences, for policymakers they are subject to all other constraints.
In countries with loosely followed legal and constitutional norms, this constraint on policymakers is irrelevant, and I treat it as a pure preference in my constraint framework. Think of Russian presidential term limits, as an example.
I incorporate legal and constitutional constraints into my forecast only when all other constraints fail to elucidate the situation. In the case of US tax cuts, I had a high-conviction view that the political constraints to passing profligate tax cuts were virtually nonexistent.8 Only when the political constraints did not help me eliminate any hypotheses did I turn to possible legal constraints: Republicans' ability to pass legislation that would blow out the budget deficit.
Early on in President Trump's administration, he threatened to start a trade war with China, end the Iran nuclear deal, and repeal Obamacare. But the most market-relevant issue was whether he could follow through on passing the corporate tax cut. Many investors were unsure he could do this with the budget reconciliation process as his only tool. Most investors believed budget reconciliation only allowed legislators to pass revenue-neutral fiscal bills. Or did it?
Budget reconciliation – “reconciliation” for short – simplifies the process of passing a budget, and it was introduced by the Congressional Budget Act of 1974.9 To illustrate why reconciliation mattered to Trump's budget cut aspirations, I first have to explain how the US Congress sets the budget.
If you think that this is a backward-looking analysis not worth your time, think again. A Biden presidency may hinge on the reconciliation process to fundamentally alter the way America's companies and investors do business. This is critical stuff (albeit still really boring).
The US budget process (Figure 7.1) begins when the US president submits a White House budget request to Congress. This step is ceremonial, as Congress has power over the appropriations process.
Congress considers the president's request – or doesn't – as it formulates a budget resolution, which both houses of Congress pass. But it is not submitted to the president and does not constitute law. The resolution sets out the guidelines for the budget process, which ideally produces an appropriations bill.
The appropriations bill, also known as a “budget bill,” cobbles together funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, both chambers of Congress are supposed to adopt the annual budget resolution by April 15. The date gives legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, Congress has no obligation or punitive incentive to meet either of these deadlines.
In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to extreme polarization. As such, “continuing resolutions” funded the government. These resolutions extend pre-existing appropriations at the same levels as the previous fiscal year.
Under President Trump, the situation has not improved. The government shut down for three days in January 2018 and then again from late 2018 to early 2019. The latter was the longest shutdown in history – 35 days – due to the failure of President Trump and House Democrats to agree on an appropriations bill.
Within this legislative staring contest, the reconciliation process was originally introduced to simplify changing the law on the books, enabling Congress to bring revenue and spending levels into line with the budget resolution in a timely manner. It was so crucial to the prospects of the 2017 tax reform because it limits Senate debate to 20 hours. The limit prevents any senator from filibustering the final legislation that emerges from the reconciliation process.
Reconciliation enabled Republicans to prevent filibuster – without having the 60 votes to invoke cloture.10 In the 2017 tax cut context, where the Republican Party controlled 52 seats, this feature of the reconciliation process allowed Republicans to pass legislation that would otherwise be filibustered in the Senate.
The reconciliation procedure is a powerful legislative tool that helps Congress pass controversial legislation, as long as such legislation affects government revenues or spending levels. Tax legislation falls under the first of these umbrellas.
George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H.W. Bush, used reconciliation to raise taxes in 1990 (to roll back some of Ronald Reagan's 1986 tax reform). The 1996 welfare reform – the Personal Responsibility and Work Opportunity Reconciliation Act – was also passed via the reconciliation process.
The one unifying feature of all reconciliation bills is that they must have an impact on the budget, by changing either the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the “Byrd rule.” Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it is equivalent to the 60-seat majority needed to invoke cloture, rendering the entire reconciliation process redundant.
While a detailed account of previously passed bills may read like dusty legal history, the closer the 2020 elections loom, it is only becoming more relevant.
Imagine the COVID-19 recession lowers the odds of a Trump second term. President Biden is inaugurated in January 2021, with a Democratic House and a slim majority in the Senate. (He picks that up thanks to the tailwinds of a recession and a median voter angry at the Trump administration for downplaying the virus threat.) The reconciliation procedure allows the newly elected President Biden to pass all sorts of legislation through the Senate chamber without a 60-seat majority. Just as Trump lowered corporate taxes with a bare minimum of a majority, Biden can increase them. Just as Obama passed Obamacare with a bare minimum of a majority, Biden can build on it. And, most relevant for investors, President Biden can use the reconciliation process – and a slim 50–50 tie in the Senate broken by his vice president – to raise capital gains taxes. And he most certainly will do that.
The investment community struggled to map out how Republicans would pass tax cuts in 2017. When the Obamacare repeal failed midyear, investors balked. They could not understand how tax reform would succeed where the Obamacare repeal had failed. A constraint-focused comparison of the two events resolves the policy puzzle: strong political constraints prevented an Obamacare repeal. But laws designed to bypass those political constraints – reconciliation – enabled Republicans to cut corporate taxes. In this special case, legal constraints eliminated both interparty and partisan political constraints.11
Reconciliation was designed to fast-track the changing of America's complex tax laws. And it worked exactly as it should have for the 2017 tax cuts. But investors in 2017 still wondered about the forecasting bottom line: would tax cuts actually be stimulative?
Uncertainty over the act's effects abounded. Investors wondered whether the Tea Party would allow President Trump to douse what remained of America's fiscal prudence with gasoline and set it alight. They doubted whether the reconciliation process would actually allow lawmakers to pass a profligate bill. Wouldn't spending cuts, or revenue-raising “offsets,” need to be included to justify the loss of revenue?
From 1980 to the 1990s, Congress used the reconciliation procedure for its intended purpose: reducing the deficit through reductions in mandatory spending, revenue increases, or both. Starting in the new millennium, Congress wielded the tool to expand deficits instead. The Bush-era reconciliation bills in 2001 and 2003 introduced large tax cuts.
Remember the Byrd rule from seven paragraphs ago?12 In addition to ensuring the bill is budget-relevant, the Byrd rule also forces any provision to expire, or “sunset,” if it increases the deficit beyond the years covered by the reconciliation bill.
In the case of the 2001 and 2003 bills, Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors remember as the “fiscal cliff” of 2013). But the sunset period does not have to be 10 years. It could be a lot longer and make tax reform semipermanent. The 2017 tax cut established a sunset of 10 years, so most of its provisions will expire in the mid-2020s.
Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015 after they retook the Senate in the 2014 midterm election.
The 2015 switch means that the procedural rules on the books allow deficits to be blown out via the reconciliation procedure. The limitless deficit possibilities enabled Republicans in Congress to be fiscally profligate, despite media punditry to the contrary. All this was happening at a time when, thanks to news reports and Republican rhetoric, most of my clients thought a budget-busting tax cut was impossible.
One constraint remained that stopped the Obamacare repeal, and might still have halted the corporate tax cut: legislative math. While House Republicans seemed on board with a budget-busting tax cut, there was the off chance that some senators would dissent. Earlier in the year, three Republican senators refused to repeal Obamacare. A fiscal hawk could hold up the legislation; one opportunistic scavenger could rob the market of the succulent carcass of a fiscally stimulative tax cut.
In Chapter 3, I emphasized how the statements of Tea Party Representative Mark Meadows helped me predict a tax cut. But there was more to my forecast confidence than just statements from Tea Party Congress members.
As it happens, Republicans did have more tools in their bottomless policy toolbox to get the job done. In particular, they could rely on “dynamic scoring,” the macroeconomic modeling tool based on the work of economist Arthur Laffer (of “Laffer curve” infamy).
Dynamic scoring estimates the outcome of tax cuts based on the theory that they pay for themselves. Headline government revenue lost through tax cuts is only half the story, as the cut's growth-generating consequences also contribute to the full economic picture. These consequences are known as the “macroeconomic feedback” of the cuts and include factors that actually add to revenues.
The Congressional Budget Office (CBO) would balk at dynamic scoring. But it was clear that “egghead, socialist economists” would not stand in the way of tax reforms. At worst, the CBO's score would force the Republicans to “sunset” tax reform legislation, but not scuttle it.
Pessimistic investors were not buying my constraint-based wares. In client meeting after client meeting, I was told that the Tea Party line of “revenue neutrality” would dismantle any stimulative impact of the tax cut. But investors were making a mistake by taking the rhetoric of revenue neutrality seriously.
The House Republicans did offer ways to offset tax cuts with revenue-raising measures: a border-adjustment tax, eliminating the deductibility of business interest payments and jettisoning the deduction for state and local income taxes for individuals. But such proposals were either draconian or insufficient to cover the cost of the tax cuts. Policymakers' path of least resistance, therefore, was to bust the budget. That couldn't be helped. Then, force the measures to expire over the life of the budget-setting window, all the while using dynamic scoring to “prove” that the cuts would actually pay for themselves.
Occasionally, then, knowledge of the legal and constitutional constraints are indispensable to accurate constraint analysis.13
The minutiae sometimes matter, especially in the forecasting field. Outside of ad-hoc constraint analysis, the forecaster's tendency is to simplify as much as possible so problems can be described in formulas and compared across time and events. Reconciliation does not fit such a convenient mold, and most clients I spoke with in 2017 did not understand its importance. Those that did claimed the Byrd rule prevented the use of reconciliation to pass budget-busting legislation. Or they remembered that the Democrats had changed the rules, ensuring that reconciliation bills could not widen the deficit – but did not recall that in 2015 the Tea Party Republicans – ironically! – had quietly tilted the rule back toward profligacy.
The reconciliation process is not the sole reason Congress could pass the 2017 tax cuts. President Trump exercised his median voter–fueled political capital on the austerity-obsessed Republicans. He had enough capital to bend them, particularly Tea Party members, to his will. The reconciliation process was only important because it allowed the investor to gauge the scenario's political constraints, i.e., whether they were strong enough to either prevent or enable the legislation to go through.
Be wary of any macro investment view that is overly technical, legal, or reliant on constitutionality. Remember the hierarchy of constraints. A good object lesson of such over-reliance is the impact of the 2016 UK referendum on EU membership. It was a nonbinding, consultative referendum and had dubious, if any, legal or constitutional power. However, it ultimately carried political weight, and so legal constraints bent to its much stronger political constraints.
David Reich and Richard Kogan, “Introduction To Budget ‘Reconciliation,'” Center on Budget and Policy Priorities, November 9, 2016, https://www.cbpp.org/research/federal-budget/introduction-to-budget-reconciliation; Megan S. Lynch, The Budget Reconciliation Process: Timing Of Legislative Action (Congressional Research Service, 2016); Lynch, Budget Reconciliation Measures Enacted Into Law: 1980–2010 (Congressional Research Service, 2017).