Clintonomics Is Failing the Market Test : Clinton took incentive out of the economy by raising tax rates; his reliance on low interest rates raises the inflation specter.

The financial markets are giving us an early test of the Clinton economic policy, and the results are not promising.

President Clinton brushed off concerns that his program of higher tax rates and more regulation would hurt the economy. The tax increase, he said, would result in a smaller deficit, which, in turn, would mean lower interest rates. And the lower interest rates would provide enough economic stimulation to offset the adverse effects of higher taxes.

For a few months it seemed to be working, but the recent decline in stock and bond prices has left interest rates higher than they were when Clinton was inaugurated. Many people are about to dig into their pockets to pay their higher taxes on April 15 and many will not get their usual refund. This decline in consumer liquidity hits the economy simultaneously with the sharp run-up in interest rates.

Clinton’s economic policy is the reverse of Ronald Reagan’s--and not because it taxes the rich. Reagan relied on incentives to push the economy. With incentives driving the economic expansion, the Federal Reserve was able to keep a tight grip on the money supply. As a consequence, the economy grew while inflation fell--a wonderful result.

In contrast, Clinton took incentive out of the economy by raising tax rates, and he regulates extensively. To drive the economy, he relies on low interest rates, or easy money.

This policy cannot work, because it results in too much money being created. The money creation gets the attention of financial markets and the Federal Reserve, and both raise interest rates, thus choking off the one factor driving the economy.

When bondholders see a money-driven expansion, they expect inflation to follow in its wake, and they bail out of their bond holdings. A wave of selling drives down bond prices, which is the same thing as driving up interest rates.

The Federal Reserve follows in turn. Its board of governors observes the sell-off of bonds and decides that it must reassure the financial market by raising interest rates. Higher interest rates are the Fed’s way of slowing the growth of the money supply. However, the Fed is fearful of stopping the economy in its tracks and usually raises interest rates in a series of small steps that follow behind interest rate increases in the market.

In the meantime, the money that the Fed has already allowed to be pumped out is doing its work expanding the demand for goods and services. But the higher taxes and regulation make the effort necessary to expand supply less rewarding. Consequently, the demand pressure starts pushing up prices instead of real output.

The 1970s proved that high taxes and easy money make a recipe for economic disaster. This policy boils down to using inflation to drive the economy. But inflation sets in motion contractionary forces of its own--rising interest rates. Remember the 20% prime rate that Ronald Reagan inherited from the stagflation of the 1970s.

The 1990s are too soon to be repeating the policy mistake of the 1970s. Bill Clinton may be too young and inexperienced to have learned the lesson of a money-fueled expansion, but his Treasury secretary, Lloyd Bentsen, has lived through it before. Why aren’t any alarms sounding in the Administration?

This question cannot be answered without taking ideology into account. The Clintons believe that Reagan’s policy benefited the successful, who are going to do well in any case, and thus gratuitously worsened inequalities in the distribution of income. Incentives have been ruled out because they are believed to result in excessive disparities in the distribution of income and wealth.

These disparities are not acceptable to egalitarians who believe that a just society is one characterized by equality of result. Therefore, they choose to drive the economy with easy money, while taxing away “excessive” rewards earned in the market.

This ideological approach to economic policy is never successful. It can work only until the monetary expansion heats up inflation or expectations of inflation. Clinton, like others before him, believes he can have a successful economy without the incentives that produce successful people. This is a delusion that has harmed us before, and it will again.