Wet-blanket boomlet; the Clinton paradox: the worse he does, the better he does. And vice versa.

THE STRENGTH of May's employment report took almost everyone by surprise. It signals a more normal recovery pace of 200,000 jobs per month, pointing toward the creation of two and a half million new jobs this year. In fact, already tiffs year the private economy has produced almost one million new jobs, the equivalent of more than two Clinton stimulus packages.

Added to this are strong increases in home sales and car and truck sales, and an ongoing rebound in business equipment spending. Profits are soaring, productivity is on the rise, and liquidity is plentiful. All in all, the economy is much stronger than people think, driven by the private sector.

This is why the Clinton program is the wrong prescription, resulting from a misunderstanding of how the economy actually works. The punishment simply doesn't fit the crime. If Congress passes the Administration's high-tax and high-spending fiscal plan, especially its harsh income- and energy-tax increases, then the economic recovery will be stifled. The wet-blanket effect will hit hardest in 1995 and 1996.

No one in Washington wants to face the unpleasant fact that a 17 per cent rollback of after-tax incentives on those with the highest propensity to save and invest will create a substantial braking effect on the economy. Indeed, Americans are facing the largest income-tax hike since World War II, reversing a more than forty-year trend toward lower statutory tax rates. What's more, by raising the cost of living and reducing the availability of goods, Clinton's plan will add a strong dose of fiscal inflation.'

Tiffs is what happens when the top marginal income-tax rate is raised from 31 per cent to 43 per cent: instead of taking home 69 cents on the added dollar earned from saving, investing, or working, the upper-income economic activists will garner only 57 cents. And remember that 52 per cent of American business--small, often family-owned businesses, partnerships, proprietorships, and subchapter S companies--also will be soaked by the higher tax rate. And for people who live in the largest ten or so cities, with state and local income-tax rates averaging 5 to 8 per cent, the top marginal rate will run upward to or even above 50 per cent.

What's more, this new tax burden is even more onerous today than equivalent percentages were 12 or 15 years ago, since nearly all of the old deductions and exemptions have been eliminated. Remember the legislative compact between Congress and the taxpayers which passed in 1986? This deal lowered income-tax rates in return for the elimination of most of the old so-called loopholes.

So, the loopholes are still gone, but the tax rates are heading north once again. This is the sort of thing that passes for fairness in today's Washington. Of course, members of Congress, the Administration, and the media keep telling us that higher tax burdens are necessary for deficit reduction. And they keep telling us that this is the first time we've really had a major-league deficit-reduction effort. What about the deal to end all deals in 1990? Or the deal in 1989? Or 1987? Or 1982? You get the message.

Added Penalties

ADDING to the penalties from

higher income-tax rates, Washington will be raising the tax burden on Social Security recipients, hiking the alternative minimum tax, and reducing the inheritance-tax deduction. Senator David Boren will most certainly not get his proposal for an indexed capital-gains tax rate. Nor will this Congress and President accede to enforceable budget caps on discretionary or entitlement spending.

In round numbers, all of this will constitute at least a 20 per cent economy-wide tax increase, which will reduce the nation's potential to grow by a similar amount, probably costing $600 to $800 billion in lost output, and roughly 4 million lost jobs, by the late 1990s. And that lost output might translate into something like $200 billion in forgone revenues which, not surprisingly, will result in higher, not lower deficits. By the way, a 20 per cent takedown of future output and, probably, of corporate earnings is bound to cause a similar 20 per cent depreciation of the value of our aggregate net worth and assets, as reflected in lower stock-market prices.

The Wet-Blanket Effect

ALL OF THIS duly said and calculated, the key economic point is still to take things one step at a time. The wet-blanket effect is not likely to kick in for about a year. Senators Boren and Nunn are insisting on a July 1, 1993, effective tax implementation date. This would suggest that we keep most of our money this year, we keep about half of our money next year, but they get all our money in 1995.

So, in terms of the present, it's important to keep in mind two large doses of economic stimulus now working through the system. First, corporate profits have recovered by $90 billion. And this recovery must be added to the flood of new equity capital offerings and debt refinancing of the past two years. From this one might expect a solid business expansion, and that is exactly what is happening, as indicated by the 16 per cent increase in spending for business equipment over the past year. Additionally, profit margins have increased substantially in key sectors such as autos, coal, construction, gold mining, semiconductors, and housewares.

Second, the Federal Reserve has been supplying high-powered bank reserves at a double-digit rate. Taking the Fed balance-sheet item "Reserve bank credit" as an example, this measure is rising at a $38- to $40-billion annual rate, or roughly 12.5 per cent growth. This excessive pace of dollar creation is the principal reason for the recent $50 jump in gold prices to $375 an ounce. Accordingly, short-term interest rates have been pushed down to thirty-year lows, and the yield-curve spread between Treasury bills and Treasury bonds is a gargantuan 375 basis points. What's more, measured against the Japanese yen, the least inflationary paper currency over the past five- and ten-year periods, the dollar has lost 14 per cent this year.

We may hope that the Fed will soon begin to lower the volume of excess reserves, thus cutting the gold rally and inflation expectations off at the knees. But this may not be so easy in the middle of a national debate over the budget and tax reconciliation bill moving through Congress. Also, since Mr. Greenspan told the New York Economics Club a month ago that the Fed is no longer targeting M2, there has been no formal announcement of which new policy variable will serve as its central target mechanism to achieve long-run price stability.

As Fed board member Wayne Angell persistently argues, gold and other financial or commodity-market prices are the best predictors of future inflation. With gold on the rise, a very wide yield curve, a weak dollar, and double-digit dollar creation, the Fed should be raising short-term rates by at least one full percentage point. Treasury-bill rates have already jumped about 50 basis points, pointing the way. But is the Fed watching? Or, what exactly is the Fed watching?

Paradoxically, the rise in short rates itself would stimulate the economy. People who have deferred spending decisions in the hope of capturing even lower future financing costs will reverse field and accelerate their buying if they begin to expect a new trend towed higher interest rates. This is the same intertemporal substitution effect as in the case of expectations of higher future tax rates. Which, incidentally, is a process now probably getting under way ahead of next year's expected tax hikes.

All told, these factors will generate a stronger economic growth rate over the next four quarters than almost anyone now thinks possible. To be sure, Clinton's policies will guarantee that this boomlet will be short-lived. But the excessive money creation from the Fed could raise the growth of nominal GDP to nearly 8 per cent. The expansion of corporate profits could lead to 4 per cent growth in real GDP. And the devaluation of the dollar in terms of gold and the yen suggests a domestic inflation rate of roughly 4 per cent.

The stock market has not yet factored in these possible outcomes, nor has it yet included the possibility of a spike in short-term interest rates. Ironically, the likely passage of 70 to 80 per cent of Mr. Clinton's fiscal plan, and the hiring of David Gergen as major domo, counselor, and defacto Chief of Staff, strongly suggests that Mr. Clinton's own stock may well be reaching bottom.

Gergen is arguably the best Washington spin doctor of the last twenty years. But it was Gergen, as George Bush's 1980 campaign manager, who coined the phrase "voodoo economics." Moreover, Gergen was an opponent of the Kemp-Roth income-tax cuts, so he can be expected to support this year's proposed income-tax hikes. Undoubtedly he will work hard to recreate the perception of Clinton as a new, moderate Democrat, and he will trumpet the passage of the fiscal plan as a great victory for the country and the Presidency.

Against this political backdrop, a surging 1993 economy will undoubtedly improve Clinton's standing. His stock has dropped from 70 per cent approval to 35 per cent. But as Gergen well knows, an investment now could yield at least a temporary capital gain later. Perversely, while Clinton's stock is likely to rise, the actual stock market can be expected to fall. Up to now, the stock market has gone up while Clinton's stock has gone down. The inverse relationship is unmistakable. A successful selling of Mr. Clinton's economics this year spells big trouble for the nation's economy after that. The 1993-94 boomlet will give way to stagflation in 1995-96. That's the trouble with good spin doctors. And bad economic policy.

Mr. Kudlow, an NR contributing editor. is chief economist at Bear, Stearns.