I am now moving from multi-year recovery to a double dip baseline

The motivating factor?  this article in Politico:

President Barack Obama plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 – and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.

The president’s plan, which the officials said was under discussion before this month’s Democratic election setbacks, represents both a practical and a political calculation by this White House.

The article, while couched in the language of fiscal responsibility and political tactics, is really an ode to the likelihood of spending cuts, tax increases or both. I see tax increases and I will tell you why later. Either way, these measures will choke off aggregate demand, making a double dip a much more likely scenario.

Below is the associated video from Politico, talking about the political calculus.

Get ready for 1937 redux – it’s coming. I warned against this before Obama even took office. But, no one in the White House is listening.

From an article here on 20 November 2008:

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted…

Just as in the two previous periods of asset deflation, we are dealing with massive amounts of debt and leverage combined with severe declines in standards of living for average citizens. In both previous cases, government thought we were out of the woods and raised taxes in order to return to fiscal prudence. On both occasions, the result was a severe recession and stock market meltdown.

Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.

I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger.

Maybe the presence of so many Clinton Administration officials is skewing this Administration’s understanding of the magnitude of the problem facing us. I don’t know. But, the White House seems to think this IS the early 1990s and we are reliving a repeat of the Clinton days. It is clearly not.

I have a lot of sympathy for the Austrian school view, although I have grave misgivings due to the likelihood of geopolitical tension and civil unrest. John Mauldin simplifies the view in a recent post:

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

And Mauldin is right. Barack Obama is not focusing on deficits in order to “get all your pain at once." This is not a Libertarian solution. The President is trying to reduce the deficit to please deficit hawks, all while perpetuating the bailout culture we have become addicted to.  This is the Japanese solution and it will not work.

Witness recent comments from Arnold Kling, who is an Austrian school economist at George Mason:

In my view, the current Administration is pro-business and anti-market–the worst possible combination. By pro-business, I mean that it likes businesses that survive on the basis of subsidies and regulatory advantages.

Now, what I fail to understand is how the Administration believes it can cut the deficit and add stimulus. James Pethoukoukis, who writes in Reuters says we are likely to see more stimulus initiatives:

How much money are we talking about? Alec Phillips of Goldman Sachs calls $250 billion over three years a “conservative” estimate. And what might be in the bill? Look for more highway spending, more aid to state and local governments and some sort of business hiring tax credit.

The only way to both add stimulus and reduce the deficit is to increase taxes – on whom is the only question. Obviously, adding stimulus while increasing taxes sounds a lot like ‘tax and spend’ and opens the door to all manner of attacks from the right. This is a huge tactical error that will be both politically damaging and unlikely to actually stimulate the economy. I see this as a potentially catastrophic outcome for Democrats. It is all too predictable although Obama is rushing ahead with this even earlier than I suspected he would.

Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

I understand the why of this i.e. the need to provide cover for moderate Democrats in 2010. But the “tax and spend” onus during a period of weakness will have people talking about shifts to the left and Jimmy Carter’s presidency – both of which are poison to moderate Democrats.

If the Administration really wants to provide cover for Moderates, a payroll tax cut or a tax break for any firm that hires X % more employees will be more targeted to the jobs problem and will avoid both the more taxes and the more spending labels.

Donald Tsang is right; America is doing exactly what Japan did last time – not just on monetary policy but on fiscal policy too. It didn’t work for Japan and it won’t work for the United States either.

Sources

After spending binge, White House says it will focus on deficits – Politico

Obama eyes domestic spending freeze – AP