Saturday, July 24, 2010
- The Least Bad Option...
I’ve been telling people that the market has become a binary phenomenon; it either soars from here, or collapses. And the choice of which we get rests in Washington.
It’s no secret that next year Obama will seize the banner of fiscal responsibility and start raising taxes to pay for all the money he’s given away. This is being called a ‘Tax Tsunami’ in the media for the effect it will have on our still fragile economy. The amount of taxation that it will take to make any meaningful dent in even our medium term fiscal problems will almost certainly shove us back into an even deeper recession. Unemployment will begin to rise and accelerate again, and the private sector will all but give up the ghost.
The odds are good that after November, Congress will be more reluctant to give him what he wants. But the government’s books have been so mismanaged that we can’t get on a fiscally sustainable path without pain for someone. And with Obama demanding fiscal responsibility, and the Republicans caught in their own rhetorical trap – it’s hard to imagine that taxes aren’t going up somewhere.
But the truth is, it doesn’t matter. Even if Obama finds religion (maybe someone will buy him ‘The Road to Serfdom’ or 'Atlas Shrugged' ) and he decides to slash entitlements instead of raising taxes, any responsible change in government finance will bring a reduction in GDP. Remember, a large part of our annual GDP is simply borrowed, and to end that borrowing will reduce the output number as well.
Besides, all those people collecting government money are fostering economic activity with it, and when it goes away it will take some time for them to learn how to respond. So no matter if we raise taxes or cut spending,either way the shock to our economy will be the amount of new found fiscal 'austerity' plus some multiplying effect based on it's source.
So when it comes time for it, either the government kick's the can down the road and waits for the entire economy and the federal government to collapse (which it will certainly do - and sooner than any of them realize) or they ‘do something’ and make things much worse for everyone in the short term but better in the long run.
In other words, when it comes to an austere and fiscally responsible future for America, you simply can’t get there from here. We just can't afford it right now. Well… there is one way. But you probably won’t like it.
Suppose for a minute that out of fear of a deflationary spiral (a phenomenon all too familiar to our Fed chief whose expertise is in the causes of the great depression) the Fed returned to using ‘inflation targeting’ and set a goal for 2011 of a 4% inflation rate? From the moment they made a public declaration to that effect, market forces would be set in motion to make it happen.
Suddenly there would be a large perceived penalty for hoarding cash, and the urge to spend on capital equipment and raw materials would become paramount for all businesses. Since the private sector is so much more nimble than the public, this will quickly translate into new hiring. The bond markets will fall and the stock and commodity markets will rise. And the fact is, it will all happen so fast that the Fed might not actually have to do anything further to the money supply to follow through on this target.
As economic activity increases, so too will tax revenue. And through the miracle of extrapolation at places like the GAO, the CBO and the BLS, suddenly our problems won’t seem quite as grave as they did when revenues were falling. A small increase in taxes on a growing economy won’t be nearly as painful as a chokingly high tax increase on a faltering one.
This solution will take on faith that someone in the Fed will have the strength of character to raise rates after things are back on track. And I admit to some pessimism on that front. But the whole idea of monetary stimulus is to stimulate – not to turn the world’s largest economy into a zombie. And besides, I’d bet the folks at the Fed would rather try to stop a car that’s speeding down a hill than to push the same car up another one.
Inflation has very real long term consequences, but so too does a stagnating economy. And if we’re going to be monetarists and live with the long term cost of inflation (which for the time being we certainly are), then we should at least try to ensure that we get the promised economic growth as short term benefit. It’s a lot easier to solve fiscal problems with everyone working than it is with unemployment in the double digits.
I don’t mean to pretend that I have confidence in the Fed’s ability to be responsible long term. They certainly have shown no history of it. But in my mind, we’ve reached our darkest hour. Our current short term trajectory is unsustainable in the extreme. Either the money begins to flow through the system creating inflation (hopefully modest and to be tamed later) or we fall into the vortex of deflation and economic collapse.
At the moment inflation seems the least bad choice to me.