Clinton's Fiscal Dilemma

AFTER a year and a half of sometimes tortuous spectacles, the American people have had their say. George Bush can take a vacation and drive whatever speedboat he likes. Ross Perot can leave politics, the arena he claims to hate, and return to the computer business. And Bill Clinton can leave the campaign and start preparing for the White House.

But if the president-elect, who called himself a "new" Democrat throughout the campaign, is to succeed in the White House, he will need to keep on winning the votes of the bond traders on Wall Street who hold his fate in their hands. As David Gergen of US News & World Report so aptly puts it, "This campaign [might have been] Clinton's last days of fun."

Mr. Clinton faces a dilemma. He must stimulate a moribund economy, but he must do so with a credible plan to cut the federal budget deficit. The two do not always go hand in hand. Clinton, as a self-proclaimed new Democrat, must convince the nation and the world that, in tandem with a united Congress, he has the power to manage the deficit in a way that will help strengthen the American economy.

To accomplish this, Clinton will be asked to solve not only an economic crisis, but also a political crisis. He will work with a Democrat-controlled Congress in this quest, which puts him in a strong and a weak position simultaneously.

Strong because, for the first time in 12 years, the president might have the power to ram home an entire economic agenda. Weak, because special-interest groups like the American Association of Retired Persons will try to bloc the necessary Social Security reforms, while the American Medical Association will look out for any attacks upon Medicare and Medicaid the new president might seek.

On Wall Street, fear abounds. It is reflected in the large gap between short-term interest rates that the Federal Reserve Bank controls and long-term interest rates that the credit markets control.

Interest rates on short-term government securities are at approximately 3 percent, pushed down by repeated Federal Reserve Bank reductions in the discount rate (the interest rate that the Federal Reserve charges member banks) since December 1990. Meanwhile, long-term interest rates, which influence business decisions on investment in plant and equipment, and real mortgage rates remain relatively high, at or near 7.5 percent.

What accounts for this difference? Long-term lenders demand a higher rate of interest on loans because they believe that the United States government will be unable or unwilling to reduce the federal budget deficit. Since an expanding deficit creates the perception of increased levels of government demand for capital, interest rates are pushed up. When long-term interest rates are high, long-term private investment - the engine that drives the economy - is crowded out.

To avoid an investment crowd-out, the Clinton administration must stimulate the economy without heightening the skepticism of credit markets. Reportedly, Clinton's economic advisers are contemplating a combination of accelerated infrastructure spending programs and temporary investment tax credits.

An acceleration in infrastructure spending would be added to the $150 billion highway bill that Congress passed last year. But one Senate Budget Committee staffer questions what benefits more infrastructure spending will have on employment in the next year.

Investment tax credits (ITCs) seem to be the better option. "The stimulus that will come from a year-long, 10 percent investment tax credit on new plant and equipment purchases may give the economy $15 billion of stimulus, but that's peanuts," says Lawrence Kudlow, chief economist at the investment house Bear Stearns. "We need permanent ITCs and accelerated depreciation write-offs to restore business confidence."

Regardless of the fiscal stimulus Clinton picks, he must calm financial-market worries about an out-of-control deficit. Legislating deficit reduction is the easy part; enforcing it is more difficult.

Can Clinton do it? Not likely, according to economist John Makin of the American Enterprise Institute. "Deficit reduction will require spending-growth caps on the popular Social Security and government health programs that have remained totally untouched in all of the deficit-reduction battles during the past 10 years. In order to contemplate such cuts the Democrats will demand tax increases that ultimately will result in higher taxes on everybody in the upper half of the income spectrum," says Mr. Makin .

It is doubtful whether Republicans and conservative Democrats, always sensitive to "tax and spend" changes, will swallow such medicine. The new president will need to wield a strong stick to break the backs of special interests who keep a watch over the mandatory entitlement programs which now account for more than 60 percent of the federal budget.

Only if Clinton is tough enough to take on many of his own constituents and clever enough to persuade his Democratic colleagues in the Congress to get tough on spending, can he succeed in quelling the fears of credit markets.

No wonder Wall Street is skeptical. Bill Clinton waged a brilliant campaign, but he also is seen by many as overly political. With his eye on reelection, it is not hard to imagine Clinton succumbing to the very interests he will need to confront to achieve political and economic success. The dearth of confidence in the bond markets was evidenced Oct. 19, when long-term rates shot up from 7.3 percent to 7.6 percent as the market became convinced that Clinton would win.

A difference of 0.3 percent on a $200,000 mortgage would translate into a loss of $6,000 per year. Many in the financial community feel that Clinton must send strong messages from the start concerning the deficit.

It is true that Wall Street perceptions are often off base, but perception is what drives interest rates. If Clinton is not to crowd out private investment, he will need to reassure financial markets continuously that he is sincere about deficit reduction.

He could start by naming some deficit hawks to his cabinet. Perhaps Paul Volker as secretary of the treasury would be a step in the right direction. Only by surrounding himself with people that remind him daily of the need to be tough with the deficit will Clinton truly become the new Democrat he seeks to be. If he lacks this firmness, "Clintonomics" could quickly turn into "Carternomics."