Why The Economy Isn't Heeding Clinton's Call

President Clinton has now accepted the view that deficit reduction will produce low interest rates, and low interest rates will produce economic recovery. This mantra has become central to every speech he makes on the economy. The only trouble is that the economy is unlikely to oblige.

Recent statistics show pervasive economic softness. Unemployment in May edged back to 7%, from 6.9% in April. Housing starts dropped 21%. Consumer confidence and the index of leading indicators both fell again. Capacity utilization, though rising, remains well below the postwar average.

The longer-term numbers are even more depressing. According to the Congressional Joint Economic Committee, real growth in gross domestic product since the trough of the recession has been less than half the GDP growth rate of the average postwar recovery. Joblessness is higher today than in March, 1991, when the recession officially ended. A forthcoming study by Lawrence Mishel of the Economic Policy Institute reveals that while temporary positions account for only 1.5% of total jobs in the economy, temp jobs accounted for fully 30% of the 1.6 million new jobs created in this recovery. Mishel also shows that average real wages fell during the recovery for both blue- and white-collar workers.

In the face of this sluggishness, Congress and the Administration have convinced each other that they ought to pursue a contractionary fiscal policy worthy of a raging inflationary boom. The tax hikes and spending cuts in the budget for fiscal 1994 will reduce demand by $70 billion, to $80 billion. It is unlikely that monetary policy will offset this contraction. At its May meeting, the Federal Reserve Board's Open Market Committee (FOMC) voted to tilt slightly in favor of tighter money at the first sign of inflation. So the likely prospect is for more of the same: a vicious circle of slow growth, high unemployment, weak demand, inadequate investment--and more slow growth.

FALSE ASSUMPTIONS. The conventional view of the primacy of deficit reduction, which Clinton has unfortunately made his own, is built on several fallacies. The first is that business investment is highly sensitive to interest rates. But history shows that business invests when it anticipates customers, not simply in response to the cost of money. Real interest rates were roughly zero during the Great Depression, but there was no investment boom.

At first, deficit reduction was touted mainly for supply-side reasons: A lower deficit would produce lower interest rates and hence more investment. But lately, the Administration has embraced cheaper interest rates as a kind of Keynesian cure: Consumers now have more money to spend because they're refinancing mortgages, saving money on consumer debt, etc. By this logic, cheaper money stimulates spending, not savings and investment.

A second fallacy is the old monetarist claim that the public deficit and long-term interest rates are closely linked. Supposedly, big deficits portend inflation, which causes bondholders to bid up rates. At some extreme, this is undoubtedly true. But economic history shows that interest rates and deficits hardly move in lockstep. The missing variable is policy. Public deficits were enormous during World War II. By the late 1940s, accumulated public debt exceeded 100% of one year's gross national product. But the Federal Reserve Board of that era was committed to an accommodative monetary policy, and long-term rates remained at 2.5%. The Greenspan Fed has been easing rates since 1989 despite the persistence of large deficits.

ESCAPING THE TRAP. A third fallacy is that public borrowing crowds out private borrowing. Again, that's true at some extreme, but we are nowhere near that extreme. The problem in today's economy is that banks can't find creditworthy borrowers, not that public borrowing has depleted capital markets. To get out of the slow-growth trap, the Fed and the Administration need a long-term pact that both restores investment and keeps real interest rates very low, rather than a strategy that accomplishes one goal at the expense of the other.

Lately, flooding in the Midwest and upward pressure on commodity prices, as well as speculative increases in the price of gold, have given the Fed's inflation hawks new ammunition. But these indicators are grossly misleading. The core inflation rate remains low because the economy is ice-cold. Unit labor costs--the flipside of stagnant wages--have been increasing at about half the inflation rate. In this economy, it would be disastrous for the Fed to nudge rates up even slightly.

The Administration, for its part, needs to revive a big public and private investment package once the 1994 budget deal is complete. Public borrowing for such a program should be understood to be a direct source of higher investment, not a stimulus to demand. In this economy, the real problem is deflation, not inflation, and a big investment package, coupled with low interest rates, is necessary to jump-start growth. Unfortunately, the economy is likely to become even flatter before that reality is widely acknowledged by policymakers.

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