The New York Times

Wednesday, November 24, 1999

The Economy Doesn't Need the Third Way

By JAMES K. GALBRAITH

AUSTIN, Tex. -- At his meeting with other progressive political leaders in Florence, Italy, President Clinton said some things that were admirable -- he called for debt relief for poor nations and ratification of the Child Labor Convention -- and a few others that sounded a little far-fetched, as when he celebrated the "little genomic maps" that he said would soon be sent home with new babies.

But one bit of his commentary pointed to a serious problem with the economically conservative and socially liberal policy mix known as the Third Way. "The liberal left parties in the rich countries should be the parties of fiscal discipline," Mr. Clinton said. "It is a liberal, progressive thing to balance the budget and run surpluses if you're in a rich country today."

"Unless you have total deflation like Japan, you should always be running a balanced budget," he went on. "It keeps interest rates down for your own people, which creates jobs and lowers costs."

Yet only a few days earlier, the Federal Reserve had raised interest rates for the third time this year. The Fed today is just as inflation-obsessed as always, and neither Mr. Clinton nor the surpluses can influence it. The budget surpluses that emerged in the past two years have not kept interest rates down.

The truth is that the good economy produced the appearance of fiscal discipline, rather than fiscal discipline producing a good economy. Lower interest rates kicked off this process, beginning back in 1992, when, despite big deficits, these rates were lower than they are today. Strong economic growth, full employment and low inflation together generated a powerful flow of tax revenue. Surpluses appeared as unemployment fell and growth proved stronger than forecasters had expected; they will disappear if and when the economy goes sour.

Mr. Clinton did help the economy, in part by protecting Social Security, expanding the Earned Income Tax Credit and modestly raising the minimum wage. But Alan Greenspan, the chairman of the Federal Reserve, did more -- by doing nothing. By not raising interest rates after 1995 while unemployment fell, ignoring dire warnings that inflation would spiral out of control, Mr. Greenspan helped to create both full employment and the budget surpluses.

This brings us to another question the president raised in Florence. "One of the big debates we're having in America now," he said, "is how long we can keep this economic expansion going." This is the outstanding issue -- not least because every time in the last 50 years the budget went into surplus, save once during the Korean War, a recession followed. The mechanism is called fiscal drag: too much taxing, too little spending.

The president credited our expansion to "productivity gains of technology" -- something no one really knows much about -- and to the "power of open borders and open trade to restrain inflation," which is real enough. But the big hero, in fact, is the American household, with its stoic willingness to take out the mortgage loans, the car loans and the credit card loans that have kept the economy growing. Private household debt has exploded, as has the stock market, and neither can rise forever. And with banks consolidating and diversifying and Congress preparing punitive new bankruptcy provisions while the Fed inches rates upward, one can see the reckoning in the works.

Having built up private debts, we now need to support private incomes. We can do this by raising wages and supporting employment, by modestly expanding public-sector investments and social programs, and by further reducing tax burdens on lower-income people. If the public debt rises a bit, private debts can come back into line. Meanwhile, interest rates have to stay where they are -- or even come down next year.

Nothing works forever. The Third Way notion that progressive governments should always be running a balanced budget unless prices are actually falling is silly. Franklin Roosevelt was not wrong to run a deficit in the 1930's, and Lyndon Johnson was not wrong to run them in the 1960's. The right policy is to pursue full employment. And that may mean shifting strategies from time to time.

James K. Galbraith is an economist at the Lyndon B. Johnson School of Public Affairs at the University of Texas.