Though it may be a case of dumb luck, Clinton's plan looks like a winner

Stephen J.K. Walters

March 31, 1993|By Stephen J.K. Walters

IT might be dumb luck or it might be genius, but the Clinton recovery package is already looking like a winner.

I'm inclined to chalk it up to luck, for there's enough that is foolish or wrongheaded in the plan to suggest that this president's grasp of economics is, to put it kindly, no better than the average politician's. His stimulus plan is unnecessary, his tax hikes are counterproductive and his spending cuts are far less courageous than they must be to make much of a dent in the deficit.

One apparently minor detail of the package, however, will yield such large economic gains that we may scarcely notice the adverse effects of the rest of the plan. Best of all, this detail requires no new legislation to implement, so the gains will come -- indeed, they've already started to come -- no matter how Congress modifies the Clinton proposals.

The key element is the administration's decision to take a bold gamble on interest rates. In a nutshell, the Treasury Department has begun financing a much larger share of federal spending with short-term rather than long-term securities. The motive was simple: At the time the decision was made, long-term bonds carried an interest rate over 7 percent, while short-term bonds were at 3 percent. By shifting toward financing in the shorter term, the administration hoped to save $11.5 billion over the next four years.

It was soon clear, however, that the strategy would do much more than that. Traders in the major money centers loved the policy shift and went on a wild bond-buying spree. As a result, long-term interest rates went into free-fall. In two short weeks, rates on 30-year bonds reached their lowest level on record; rates on 10-year bonds fell to levels unseen since 1971.

Why so many ripples from such a small stone? The key is that the Treasury's move convinced lenders that the threat of future inflation is finally and irrevocably gone. Inflation is something that government can produce almost at will (by simply printing more money), and the Clinton administration has now put itself in a position where it has far more to lose than to gain from inflation. Lenders rejoiced -- and the bond rally took off.

The specter of inflation has haunted credit markets since the '70s. For example, banks which had made mortgage loans carrying fixed interest rates of 5 and 6 percent soon lived to rue the day, for by the Carter years the inflation rate had soared to double digits. This unanticipated inflation put lots of money in the pockets of borrowers: Their homes appreciated rapidly, but their mortgage liability didn't. It all came at the expense of lenders who had failed to foresee the inflationary spiral.

Once burned, twice shy. Since unanticipated inflation shifts wealth from lender to borrower, lenders simply built a larger inflationary expectations component into their rates on long-term loans -- and kept it there, even after actual inflation had subsided considerably. Lenders were smart enough to know that Uncle Sam, the world's biggest borrower, faced an awesome temptation: By printing new money at a greater-then-expected pace, he could create enough inflation to enable him to pay back his loans in depreciated dollars, greatly easing the real burden of the national debt.

But now that temptation has been removed. With the debt financed in short-term notes, any unexpected run-up in inflation will hurt the government as much as it will hurt lenders. In effect, the administration has taken itself hostage; if it is so foolish as to engineer even modest increases in inflation, it will surely perish politically. Lenders find this kind of hostage-taking reassuring.

Now that inflationary expectations have been vanquished, the recovery should pick up even more steam. Lower long-term borrowing costs will make major capital investments far more attractive to business. On the consumer side, it won't take long for lower mortgage rates to spur home construction. Lower monthly housing costs also will help.

By some estimates, every tenth of a percentage point decline in long-term rates is like $10 billion in fiscal stimulus. On this basis, 30-year bond rates have, since the election, fallen enough to deliver a $100 billion kick to the economy.

Who cares if it's the product of dumb luck? Let the good times roll.

Stephen J.K. Walters, a professor of economics at Loyola College, is the author of "Enterprise, Government and the Public."

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