President Clinton's choices for two Federal Reserve Board seats could be a signal to expect a revival of inflation. One is a self-described "inflation dove," and both are from the Keynesian school of economics that stresses consumer demand as the driving factor in the economy.
Alan Blinder, a Princeton University academic and erstwhile BUSINESS WEEK columnist currently serving on Clinton's Council of Economic Advisers, and Janet Yellen, a professor at the University of California at Berkeley, are demand-side economists. The key to demand is low interest rates, and the key to low interest rates is for the Federal Reserve to provide banks with plenty of funds to lend.
This is where matters get sticky. The easy-money policy eventually pushes up prices, and once the inflation rate moves up, the Federal Reserve can't keep interest rates down.
To stop the inflation that's pushing up interest rates, the Fed itself has to raise rates. It does this by curtailing the supply of funds that banks have to lend. This is known as "taking away the punch bowl," and the usual result is recession and unemployment.
The key to successful demand-side economic policy is political timing. Recession needs to occur early in the Presidential term so that there is ample time for the economy to recover and produce an expansion that the party in power can ride through the next election. Once the incumbent is safely reelected, the cycle repeats.
BAD TIMING. The problem for Clinton is that the economy, for cyclical reasons, is on an upswing during the first part of his term. This is bad timing. Inflationary pressures could force the Federal Reserve to yank the punch bowl before the 1996 election. Normally when this happens, the President in office gets blamed for the recession and voted out.
As Clinton's appointees to the Federal Reserve, Blinder and Yellen have the job of downplaying inflation and stressing the need for job growth. Their influence will exceed their voting power because their complaints about "excessively tight" monetary policy will resonate with the Democratic Congress, which can threaten the Fed's independence.
The politics of monetary policy are complicated by the fact that the bond market knows this and will put its own interpretation on events. If it looks as though the Federal Reserve is going to be tardy in resisting inflation, bond traders will unload their holdings, thus driving up interest rates. So Blinder and Yellen could succeed in stalling Federal Reserve action to no avail.
Clinton is stuck with the political interest-rate cycle because he denigrated President Reagan's supply-side policy and loaded his Administration with demand-side economists. This was a mistake, because supply-side economics doesn't rely on low interest rates. Instead of pouring money into the economy to stimulate demand, supply-side economics pours incentives into the economy to stimulate supply. Reagan relied on lower tax rates instead of lower interest rates to stimulate the economy. This freed him from "stop-go" Fed policy. With lower tax rates encouraging people to produce more income, the Federal Reserve didn't need to stimulate the economy by printing money and could focus on bringing down the inflation rate.
LESS GREED? Reagan's supply-side policy allowed him to achieve the record for the longest peacetime economic expansion in our history despite high real interest rates. Eighteen million new jobs were created while inflation fell. Clinton's demand-side policy is unlikely to duplicate Reagan's success because it relies on low interest rates that cannot be maintained once easy money pushes up inflation. As its history shows, demand-side economics cannot deliver economic growth without inflation. That's why Blinder and Yellen will soon be arguing that a little more inflation won't hurt.
Keynesians don't make good inflation fighters because they blame inflation on nonmonetary factors. In place of too much money chasing too few goods, Keynesians blame greed: Prices are pushed up by greedy oil sheiks, greedy labor unions, greedy businesspeople, and greedy commodity speculators. The same people who deride the 1980s as the Greed Decade attribute the decline in inflation in that decade to less greed on the part of oil sheiks, unions, businesses, and speculators. Apparently, any contradiction is better than giving supply-side policy credit.
Blinder thinks we should just accept inflation as a redistributive device that hurts the rich more than the poor. Reagan, it turns out, protected wage earners by indexing the personal income tax for inflation--but did not do the same for the capital-gains income of the rich. If inflation gets out of hand, Blinder says we can suppress greed with wage and price controls. The Clinton Administration doesn't connect monetary policy with inflation. The 248-page 1994 Economic Report of the President, which Blinder helped to write, devotes three paragraphs to monetary policy---one less than it gives to the disinflationary effect of lower oil prices.