Inflation and the Democrats.

President Clinton has not said much about inflation; which theoretically leaves open the possibility that he may be a hard-money man. But don't count on it. For starters, he's a Democrat.

Perhaps the most disturbing aspect of President Clinton's insistence on pressing ahead with an economic-stimulus program despite universally positive economic data (including a 4.7 per cent growth rate in the fourth quarter and the biggest increase in payroll jobs in ten years in February) is the cavalier attitude it signifies toward inflation. This growth-at-all-costs approach may not show up in price indexes for some time, but continuation of such a policy will inevitably mean inflation.

To a certain extent, a revival of inflation is the unavoidable result of having a Democrat in the White House. Clearly, one of the major factors differentiating parties of the Right and of the Left in all countries is their relative concern for inflation on the one hand and unemployment on the other. Parties of the Right, including the Republican Party, tend to represent the creditor class, which is hostile to inflation because it destroys their wealth. Conversely, parties of the Left, including the Democratic Party, tend to represent the debtor class, which benefits from inflation by having their debts liquidated. John Maynard Keynes illustrated this point graphically in 1922:

The tendency of money to depreciate has been in past times a weighty counterpoise against the cumulative results of compound interest and the inheritance of fortunes. It has been a loosening influence against the rigid distribution of old-won wealth and the separation of ownership from activity. By this means each generation can disinherit in part its predecessors' heirs.

Consequently, if there is a perceived conflict between inflation and unemployment - the so-called Phillips Curve trade-off - democrats will tend to favor less unemployment, while Republicans will tend to favor price stability. The chart on page 36 illustrates this fact by showing the inflation rate during the first and the last years of recent presidential Administrations. The unmistakable conclusion is that inflation tends to rise when Democrats are in office and to fall when Republicans are.

I Say Tomato . . .

The cause of this phenomenon does not lie solely with the nature of the constituencies represented by each party; it also results from different outlooks on what causes inflation in the first place. While both Republicans and Democrats agree that inflation results from an excess of demand over supply, Democrats tend to view the problem from the perspective of supply, with inflation resulting from inadequate productive capacity rather than excess demand. Republicans, by contrast, generally view inflation as exclusively a demand-side phenomenon.

In addition, the two parties tend to have different views about the relative importance of monetary and fiscal policy. Democrats tend to be Keynesians, viewing fiscal policy almost exclusively in terms of the deficit. Deficits are viewed as inherently stimulative, and it makes no difference whether a deficit results from higher spending or lower taxes. (By the same token, it does not matter whether deficits are reduced by higher taxes or lower spending.) Monetary policy plays no major role in this model other than passively accommodating fiscal policy.

Republicans, on the other hand, tend to be monetarists, seeing inflation as resulting largely, if not exclusively, from excess demand caused by excessive money growth. Budget deficits, on this view, are not inherently stimulative: they have that effect only insofar as they force the Federal Reserve to increase the money supply. Moreover, in the Republican model, it makes a great deal of difference whether deficits result from higher spending or lower taxes. (And therefore, it makes considerable difference whether deficits are reduced by higher taxes or lower spending.) Higher spending and taxes increase government's share of output and are inherently anti-growth, while lower spending and taxes are stimulative.

In summary, Democrats tend to favor a loose money policy and react to inflation by tightening fiscal policy. Thus, Lyndon Johnson strongly attacked Federal Reserve Chairman William McChesney Martin in 1966 for tightening monetary policy when the first signs of inflation began to emerge. Martin unfortunately backed off, setting in motion an inflationary spiral that would last for a decade and a half Later, when inflation could no longer be ignored, Johnson reacted by raising taxes, with a 10 per cent income-tax surcharge in 1968.

Past as Prologue 

What does this tell us about inflation in the Clinton era? It is hard to say with certainty because inflation was not an important issue during the campaign and he was not compelled to explain clearly his views on the subject. Clinton's few comments on monetary policy have been vague and inconclusive. Perhaps his most significant comment came at the end of his economic summit, when he said that he would oppose higher interest rates unless there was serious evidence of a return to inflation." Clinton further indicated that as long as there is under-utilized capacity in the economy inflation is unlikely to develop.

Another clue to Clinton's thinking may be found in an important article by his closest campaign economic advisor, Robert Shapiro, published in the Winter 1982 issue of The Public Interest. In this article, Shapiro basically says that the Federal Reserve's independence is a myth, that it is above all a political institution whose behavior must be analyzed as such. To the extent that the Fed has a guiding principle, it is to support Treasury's borrowing above all else, thus subordinating the goals of price stability and maximum growth in the economy. Therefore, reducing deficit spending is the essential precondition for getting the Fed to follow a growth-maximizing monetary policy. Otherwise, its preoccupation with financing the deficit will always dominate its decisionmaking.

While one cannot say that the views of one advisor necessarily indicate what President Clinton's policy toward the Fed will be, Clinton's policy thus far seems consistent with Shapiro's analysis. Clinton clearly views the Fed as a political institution and treats it in much the same way as he treats Congress. This means utilizing the full range of weapons in the presidential armory to achieve whatever result he wishes, including persuasion, flattery, and, ultimately, raw power. With consummate political skill Clinton moved quickly to soften up the Fed, inviting Alan Greenspan down to Little Rock for private consultations shortly after the election and inviting him to sit next to the First Lady during Clinton's own first address to Congress. This is the carrot; later comes the stick.

While the President's comments thus far have been in support of the Fed's independence, one cannot take this as a definitive indication of what he will do when the crunch comes. That crunch will come when the Fed sees the early signs of inflation reemerging and moves to raise rates and tighten monetary policy. If Clinton believes such tightening jeopardizes his re-election chances, by slowing the economy going into 1996, there is little doubt that he will react the way Johnson did in 1966. (Keep in mind the monetary policy affects real growth with a lag of one and a half to two years, as Clinton well knows.)

Thus far, Clinton has been rewarded with supportive statements from Greenspan on his economic program, in sharp contrast to Arthur Burns's highly critical comments on Carter's program in 1977. He has also seen interest rates fall to their lowest levels in a generation, as bond markets respond to the prospect of lower deficits and a stable monetary policy. However, this may simply be the calm before the storm. A recent report from Bear, Stearns & Co. notes that some important early warning signs of inflation are already in evidence:

- Treasury-bill rates are currently well below nominal GDP growth, which in the past has been a sign of easy money and future inflation.

- The Federal Reserve has been increasing the money supply at a rapid rate.

- Indexes of future inflation, such as the Purchasing Managers' price index and various commodity prices indexes, are rising sharply.

- Higher taxes, by reducing output, will make a given level of money growth more inflationary than it would otherwise be.

Of course, other signs of inflation, such as the price of gold and the monthly CPI, continue to indicate price stability. However, once inflation definitely is on the rise gold can shoot up instantly, while the CPI will always lag far behind. This is the most disturbing aspect of Clinton's comment about not tightening until the signs of inflation are unmistakable. By the time inflation shows up in the CPI it will be too late.

Gonzalez on the Attack

Another important element in the equation is Congress. There have been signs for several years that Congress would like to curb the Fed's independence. This year those plans may become more concrete. Henry Gonzalez, chairman of the House Banking Committee, has already introduced legislation to require that regional Federal Reserve Bank presidents, who serve on the Federal Open Market Committee (FOMC), the key policymaking arm of the Federal Reserve, be nominated by the President and confirmed by the Senate for their positions. At present, they are appointed by the private board of directors at each of the 12 regional banks. This has tended, in the view of many Fed-watchers, to insulate them from politics, making them more resistant to pressure for monetary ease than the seven presidentially appointed members of the Federal Reserve Board who also serve on the FOMC. In the past, the Fed has viewed any effort to make the regional bank presidents more politically accountable as an attack on its independence.

Another important bill attacking the Federal Reserve's independence has been introduced by Representatives Lee Hamilton and David Obey and Senator Byron Dorgan. Among other things, it would allow the President to appoint a new Fed chairman one year after taking office. (Alan Greenspan's term as chairman, for example, runs until 1996.) New Presidents must often wait years to put their own man at the helm of the Fed; they would also require Fed actions to be revealed immediately, rather than six weeks later as is now the case. And they would require the Fed to be more accountable for its own budget, which is now entirely exempt from congressional review.

Finally, one cannot help noting an increase in both the number and the intensity of congressional statements attacking the Fed. Senator Paul Sarbanes, for example, reflects the views of most Democrats when he says that any effort to raise interest rates would be "completely inappropriate." Senator Jim Sasser has accused the Fed of wearing monetary policy "Like a hair shirt." Congressman Lucien Blackwell has bluntly said that if Congress does not see sufficient cooperation from the Fed, "we should consider measures to make our central bank more responsive." He suggested that we might wish to simply make the Fed an executive department, like the Department of Education.

Given such activity, it would be an easy matter for President Clinton and the Democratic Congress to play good cop, bad cop. If the Fed behaves, Clinton will rein in the congressional bomb-throwers; if it doesn't, he may turn them loose.

While President Clinton may yet turn out to be a closet hard-money man, the odds are strongly against it. And, as Bob Shapiro correctly stated in that Public Interest article, when faced with a choice between doing what is right and protecting its "independence," the Fed always protects itself. While Greenspan and Co. have not yet been forced to make this choice, the day will come. Prudent investors would do well to buy a little gold just in case.

Mr. Bartlett, a visiting fellow at the Cato Institute, was deputy assistant secretary for economic policy at the Treasury Department under Presidents Reagan and Bush.