The Pact Clinton Should Make With The FedRobert Kuttner
Bill Clinton must devise an economic strategy that ignites a recovery, enlists the help of the Federal Reserve, and doesn't unduly scare the money markets. Given the overhang of a $290 billion deficit, this tightrope act seems well-nigh impossible. A stimulus program would necessarily rely on increased government borrowing. To money markets, that signals inflation and falling bond and stock prices. In the two-stage scenario increasingly popular among economists, Clinton could offer a sort of Gramm-Rudman III--an automatic deficit-reduction formula to be triggered by higher growth. But the jaded money markets have seen such triggers before, no-
tably Gramm-Rudman I and II. They never quite fire.
What to do? If Clinton errs on the side of excess stimulus, he could panic the money markets. The fragile markets are already primed for a blowout--which would be blamed, however unfairly, on the new President. Conversely, if he errs on the side of excessive prudence, he will be blamed for continued stagnation.
CHRONIC WOES. Clinton must begin by enlisting the support of the Federal Reserve. Only if the Fed choses to be a prisoner of the money markets will Clinton be such a hostage, too. Chairman Alan Greenspan, like Paul Volcker before him, has the power to help the Chief Executive--or ruin him. As a pragmatist, Greenspan may want to work with the new team. Alternatively, as a longtime Republican loyalist, Greenspan, 67, may wish to step aside. Either way, Clinton needs the Fed in his corner from day one.
The economy is suffering not just from a business-cycle recession but from chronic depressed growth--a "contained depression," in the words of economists S. Jay Levy and David Levy. It is also suffering the aftereffects of the 1980s--a high debt load, weakened banks--as well as the depressive impact of conversion to a peacetime economy and of corporations shedding employees in a race to cut costs. Unlike the stagflation of the late 1970s, today's maladies distinctly do not include inflation. That gives the Fed a lot of room to continue easing monetary policy.
In this climate, with private investment depressed, there is certainly room for more fiscal stimulus, initially targeted to public investment. For its part, the Federal Reserve should worry more about recovery and less about money-market jitters. At some point, higher growth could arguably invite some "crowding out" and inflationary pressure. But the time to cool the economy would be then, not now.
To begin with, Clinton and Greenspan should agree to a long-term compact of low inflation and low real interest rates. Unlike Bush, who presided over divided government and fiscal gridlock, Clinton will have the broad backing of Congress. If Clinton is shrewd, he will line up Greenspan, the House and Senate leadership, and--why not?--Paul Tsongas and Ross Perot for good measure, and jointly commit to a solemn compact of recovery now, long-term low interest rates, and gradual deficit reduction when growth returns.
NEW FACES. But what if the money markets still sniff inflation and bid up rates? The Fed likes to insist it lacks the power to affect long-term interest rates. But that view is far too modest. Several studies have shown that the yield curve--the relationship of short-term rates to long-term rates--is not much different from its typical shape at this stage of a business cycle. Short-term rates are disproportionately lower than long rates just before a recovery takes hold. The real problem today is not the gap between short- and long-term rates; it's that rates are too high generally. If the Fed keeps easing, long rates will come down, too.
If a fearful or irrational bond market tries to bid up long rates, the Fed and the Treasury Dept. do have ways of counteracting it. They have resisted, not because such intervention is technically unfeasible, but because it is ideologically unfashionable. One strategy, commended by Nobel laureate Robert M. Solow of Massachusetts Institute of Technology, would have the Treasury (through its mix of maturities) and the Fed (through its open-market operations) make 30-year bonds more scarce. That would raise the price of such bonds and lower their effective yield. Another tactic, long proposed both by fellow Nobelists Milton Friedman (conservative) and James Tobin (liberal), would have the Treasury issue some bonds indexed for inflation. This would guarantee a real fixed return and squeeze out the "inflation premium" that wary investors demand for lending long.
If all present members of the Federal Reserve Board of Governors serve out their terms, the board will stay in Republican hands well into the '90s. Several, however, are making noises about wanting to go elsewhere, especially now that a Democrat is in the White House. Hence, a majority could be Clinton appointees early in his term. How Clinton handles the delicate business of stimulating a recovery, winning the Fed to his cause, and reassuring (but not pandering to) the money markets will be the first big test of his Presidency. It could well determine whether his economic program succeeds or fails.