LOOKING AT Clinton’s America : But What Do the Markets Think?

One of the major political transformations of the past decade has been the recognition by the mainstream of both parties that capital markets impose absolute--and apolitical--limits on the freedom of action of the federal economic machinery.

A great whoosh of relief could be clearly heard from the Clinton transition team when Wall Street reacted positively to the selection of Sen. Lloyd M. Bentsen (D-Tex.) as the next secretary of the Treasury. Although Bentsen has rarely seen a tax break he didn’t like, especially if it benefited Texans, he has been making the appropriate noises about deficit reduction and higher savings. In any case, the most accurate barometer of professional opinion, the bond market, which had been slipping since late summer, rose strongly on news of the appointment.

Though Bentsen’s credentials as a scourge of federal profligacy may be somewhat suspect, there can be no qualms about Clinton’s second-rank economic appointments. Roger C. Altman, vice chairman of the Blackstone Group, a New York investment bank, will be Bentsen’s deputy; Robert E. Rubin, co-chairman of Goldman, Sachs & Co., will head a new economic security council, charged with coordinating overall Administration economic policy.

Both men are known as liberal Democrats, yet they are Wall Street veterans with intimate appreciation of the workings of capital markets. Rubin has presided over an extremely successful period of growth and profits at Goldman’s. Although Altman is only 45, he was an assistant Treasury secretary in the Carter Administration, and has long been associated with Peter G. Peterson, Blackstone’s chairman, and perhaps the country’s most consistently outspoken curmudgeon on the need for controlling deficits.

This visible concern in the Clinton camp about good reviews among financial professionals is a new phenomenon, particularly in Democratic politics. Twenty years or so ago, it was virtually academic orthodoxy that an Administration had sufficient economic clout to impose its policies on markets rather than vice versa. Pleasing the markets was treated more as a cosmetic requirement than as a fundamental policy objective.

John F. Kennedy appointed Douglas D. Dillon, a Wall Street stalwart, as his first Treasury secretary, but regarded the capital markets as a hostile force, intent on wrecking his progressive policy initiatives. Lyndon B. Johnson, characteristically, tried to fool the markets by strong-arming his economic forecasters into concealing his budget-busting Vietnam spending.

Richard M. Nixon relied on sowing confusion. Worried that inflation threatened his reelection in 1972, he broke the link between the dollar and gold and imposed wage-and-price controls to create a brief false prosperity that transmuted into a major recession just as the Watergate scandal broke.

Gerald R. Ford and Jimmy Carter tried to muffle oil-price increases by printing money so prodigally that they created a firestorm of global inflation. Then Ronald Reagan fought for tax cuts, but not for spending cuts, helping to create the debt overhang that, in the final analysis, sank George Bush’s presidency.

Taken altogether, that is a remarkable run of fiscal and monetary irresponsibility. The financial markets have it burned into their brains that almost all federal Administrations are pro-debt, pro-inflation or pro-anything that will pump up the economic numbers in time for the next election, regardless of the long-term costs. So when Bill Clinton starts talking about “jump-starting” the economy, market professionals conjure up images of the 1970s, when inflation was so high that borrowers could make a profit by running up debt and paying back in cheap dollars.

But the Clinton camp seems convinced that jittery financial markets will substantially limit its freedom of action. And, in fact, it is the bond market, not the federal government, that determines long-term interest rates. The Federal Reserve has pushed down short-term rates for more than a year, but the long-term bond has stayed stubbornly fixed at about 7.5% or above. It is the long-term rate that is the critical determinant of the level of capital investment, of new construction, of the health of the housing market--the core of a modern economy. If Clinton cannot count on lower long-term rates, his hopes for stronger, steadier growth will be badly disappointed.

The “bond-market” is a relatively small number of trading professionals--probably numbering in the low thousands--who hold and trade bonds for big portfolios. Their primary concern is the value of their holdings. A bond is simply a contract to make a specific series of payments to the holder. To take a simple example, a $100 perpetual bond with a 5% interest rate is a contract to pay the holder $5 a year forever. If rates rise to 10%, a new buyer will pay only $50 for a bond with $5 coupon. Automatically, that is, the value of the original bond has been cut in half.

If market professionals are worried about inflation, they try to sell their holdings before interest rates rise and reduce their bond values. In the rush to sell, holders cut asking prices in order to increase the returns to buyers. But increased returns are the same as higher interest rates; fear of inflation itself, that is, will cause interest rates to rise.

Clinton campaigned on a commitment to stimulate the economy. The conventional ways to do that are to increase federal spending on highways, lower taxes, increase the federal deficit and print more money. All these solutions are likely to trigger inflation in an economy that is already growing by itself.

The lead time between conceiving federal policies in Washington and translating them into the real world is so long that bond professionals reasonably fear a Clinton stimulus will hit the economy late next year--when it is moving into high gear on its own. If those fears translate into a jumpy market and rising interest rates, fear of excessive stimulation could itself choke off a Clinton recovery, or even trigger another recession.

The first reaction from Wall Street is that Clinton’s economic appointees understand this delicate interaction between capital markets and federal policy, and that their stimulative policies will be cautious and judicious. Only by respecting the new limits on federal action, that is, can Clinton ensure that a “Clinton recovery” lasts a long time.