Saturday, August 14, 2010

Recession, Deficits, Interest Rates and Inflation

In order to manage its troubling budget deficit and ballooning debt, the federal government will be forced to either raise revenues (taxes) or cut spending, or a combination of both.

However, since the private sector is barely growing, the government will find it difficult, if not impossible, to increase tax revenues. There isn't enough economic growth to result in higher revenues, and tax hikes could actually shrink the economy further and worsen our position. Ultimately, a shrinking economy results in an even higher debt-to-GDP ratio.

Christina Romer (head of the President Obama's Council of Economic Advisors) and her economist husband, David, did some fascinating research. Tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. In other words, if you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases.

Keep in mind, this research was done by a couple of Democrats — not Republicans — so this is not just a GOP talking point.

So, with the government desperately in need of revenues as the tax base continues to shrink, allowing the Bush tax cuts to expire will have a dampening effect on the economy. That will continue to shrink the tax base. It's just a vicious circle.

Both Alan Greenspan and Tim Geithner (who each originally advocated for them) are now calling for the Bush tax cuts to be allowed to expire as scheduled on December 31.

As the economy sinks into a double-dip recession, the government will be compelled to enact another round of stimulus, which will ultimately push deficits even higher.

What's more, the federal government will soon be forced to bail-out bankrupt state governments that can't meet their obligations.

The problem with deficit spending in a shrinking economy is that, as the tax base is shrinking, the public debt is exploding. This is a recipe for disaster.

The government will be forced to borrow even more money, expanding its debt even further. This will eventually result in higher interest rates, which will lead to even higher and more burdensome debt payments.

If the economy remains weak, and the private sector is not competing with the public sector for capital, Treasury yields should remain low. That will only encourage even further deficit spending. The conundrum is that the weak economy will make it difficult, if not impossible, to pay off our debts.

The US will just continue to issue new debt to pay off old debt, until the market stops lending. At that point, the jig is up. That's when a debt crisis / currency crisis erupts in the US.

That will be one hellacious event.

Given the risk of a future US debt / currency crisis, it seems that current — and historically low — Treasury yields do not offer investors either fair-market compensation or security in the event of such a future crisis.

If investors become too averse to this risk, the government will have no other option than monetizing the debt, which will devalue the dollar and spur price inflation.

When the supply of money exceeds the supply of goods and services, prices will inevitably rise.

While that may be an eventuality, the Federal Reserve is so concerned with the prospect of deflation right now that it plans to continue pumping more money into economy by purchasing additional Treasuries, and likely more mortgage debt as well.

The US government — and, consequently, the American people — is in one hell of a stew right now. The problems facing the US are manifold, and they are so weighty that they will change the nation in rather profound ways for years to come — perhaps irrevocably.

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