March 7 (Bloomberg) — Democrats made a deal with themselves long ago.

When it came to economics, they would back less government involvement abroad and more of it at home. They would push for freer trade, as Bill Clinton did for Nafta, even as they worked for higher taxes, with his decision to lift the cap on the Medicare levy. The two positions go together, just as opposing the estate tax and undermining abortion rights unite Republicans.

There are a number of reasons for the Democratic trade-off, the first of which is cynical.

Being for free trade is like putting on a Brooks Brothers blazer when you go to a meeting. It makes you seem reasonable — a little humble, maybe, but definitely reasonable. And if the Democrats seem reasonable, they have more authority to argue for arrogant, unreasonable domestic policies such as raising taxes, opening union balloting on the factory floor, or a costly universal health-care program.

Now Hillary Clinton is casting off the blazer. This past week, the Democratic candidate for president told her colleagues in the Senate that too much free trade is bad — more specifically, too much free trade of currency.

Recent declines in Western stock markets, coming as they did after that wrenching drop in Shanghai, demonstrated that the U.S. needs to monitor foreign purchases of U.S. debt, she said. Without a new policy, the New York senator warned, "we can too easily be held hostage to the economic policies that are being made, not in Washington and not in the markets of New York, but in Beijing, Shanghai, Tokyo and elsewhere."

Letter to Hank

Clinton also sent a letter to Treasury Secretary Henry Paulson, saying it is "undeniable that the exponential growth of foreign debt in the last six years has undermined our economic standing." She is concerned about an "erosion of U.S. sovereignty."

Clinton asked Paulson and Federal Reserve Chairman Ben Bernanke to consider creating an alarm bell that would ring when foreign-owned debt crossed 25 percent of U.S. gross domestic product, or when the trade deficit crosses 5 percent of GDP.

Paulson politely suggested she was off base, and he was correct. Her statements betray a deep misunderstanding of capital flows. It's important to recall what happened after last year's coup in Thailand. The new government had concerns about sovereignty and influence. So it slapped on capital controls. Instead of surging at the news, the Thai stock market collapsed. The embarrassed junta later undid much of its work.

Something Radical

When a government does something radical to reduce uncertainty, it often creates more uncertainty. Big steps by new governments are especially treacherous. Instead of protecting the U.S., Clinton would be giving the entire world a statistical marker to use for programming sell orders.

And the wrong statistical marker, to boot. If you really are concerned about all the international capital that has sloshed into the U.S., the best thing you can do is ensure that the economy remains competitive enough to keep the money from sloshing out.

A more acceptable bell might be one that rings whenever U.S. productivity gains narrow against those of other nations, or against a historic average.

Another fine bell would be one that rates U.S. long-term budget shortfalls against those of, say, European nations.

A Gramm-Rudman bell may be good for fiscal conservatives — it could ring after too much congressional spending, just like the old budget-balancing law. That would tell the world when the U.S. was becoming too undisciplined to care about what it did with foreigners' money.

Making a Deal

Yet the real reason that Hillary Clinton's foreign-debt warning is counterproductive has to do with the old Democratic deal on entitlements.

Clinton has said she wants universal health-care coverage, a program that will cost the federal government down the road.

Only sustained free trade can make such dreams possible. Simple but true: Trade fosters market transactions that help the U.S. produce the extra tax revenue to fund long-term care. Capital inflows bring down interest rates so the lower-earning constituencies that are traditionally Democratic can buy houses. Hence, the homeownership rates Republicans tout so triumphantly.

There's yet another issue, which even those on the Democratic left understand. It is that free trade does all this without hurting employment. U.S. unemployment reached a half-century low of 3.8 percent for one month in 2000, six years after the North American Free Trade Agreement went into effect.

So for an entitlement Democrat to be pro-free trade isn't merely cynical. It's also logical.

Clinton may shift her trade position. Maybe this was just a test of the idea. But the foreign-money question confronts everyone, including Barack Obama, Clinton's opponent in the primaries, whose health-reform timetable is more aggressive than hers. All candidates, Republican or Democratic, will want to think hard before they scare off foreign investment. It is part of a deal that we want to be in.

(Amity Shlaes, a visiting senior fellow at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

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