Reagan Era Economic Changes Will Influence Democrats in ’88

Something basic has been occurring in financial markets since the end of March that may change political history even as it is being written.

Low inflation and large government deficits generally are thought to be incompatible. Democrats in Congress remain perplexed by a Republican Administration able to cure inflation while racking up the largest budget deficits in history. Then the missing link was discovered. Suddenly everyone knows that foreign lending, particularly Japanese purchases of U.S. Treasury paper, has enabled us to finance trillion-dollar deficits with only a modest inflation penalty.

However, Boyles’ law of physics operates in business and politics as well. Foreign investors and governments are demanding ever higher interest rates to finance our deficit, as the value of the dollar declines. Inflation is up too, as we convert our cheaper dollars to import more expensive foreign products.

Economics is a subtle but powerful determinant in presidential politics. There is a strong likelihood that credit tightening combined with higher inflation will help elect a Democratic President in 1988. Voters will probably not recall the double-digit inflation and 18% prime rate of 1979 as clearly as they might, but they will take note that economic conditions are not as cozy today as a year ago and they are getting worse.

If these events come to pass, what likely direction will domestic policy take in a new Democratic Administration? Probably a much more conservative path than post-Depression political history would suggest. Regardless of whom Democrats nominate, future spending choices have been prescribed by the Reagan presidency.

The budget deficit during the last seven years has been enlarged and rearranged in a fashion that effectively precludes a Democratic President and Congress from returning to the tax-and-spend policies of the past. Interest on public debt must be repaid regardless of how it was incurred. A strong defense will be maintained and a Democratic tendency to rely on conventional rather than nuclear forces is an expensive proposition, all morality aside.

Politically, it will be difficult to raise revenues by raising taxes. Our top tax rate will drop to 28% in 1988 and the tax code is now indexed, so government can no longer count on inflation to provide a hidden revenue source. Key Democrats in Congress were authors of tax reform, and will not easily or quickly exchange higher tax rates on the middle class for new spending.

Spending will be the likely casualty, as painful as this will be for politicians of either party. The new ideas of 1988 and beyond are being framed as much by fiscal necessity as by ideology. Proposals to govern that take account of new fiscal realities--mandatory military and public service, workfare, incentive-based compensation, and privatization--are proving to be more Democratic than Republican in origin. This is healthy for the Democratic party and for the nation should the party assume power in 1988.

If a Democratic Administration were to inherit a base of 3% annual inflation and 7% interest rates, powerful constituencies within the party would clamor, perhaps successfully, for reflation and traditionally oriented spending initiatives.

Given deficits that are already compounding at a frightful rate and the commensurate abdication of economic control to the whims of foreign investors, we could quickly return to an era of hyperinflation and high interest.

On the other hand, if the legacy is 6% to 7% inflation and somewhat higher interest rates, New Deal pump priming will prove much too risky to consider. In this situation the Democratic leadership will likely opt to pursue fiscal responsibility in practice as well as rhetoric, while embracing the new approaches to domestic policy now being articulated by the myriad of Democratic presidential contenders.

If a fiscally responsible Democratic Administration sounds far-fetched, remember: It was the Republican President Richard M. Nixon who went to China.