If the U.S. continues on its current path, it will be experiencing full-blown stagflation by the time of the 2012 election. On fiscal policy, the only debate between the two parties is over how much to cut. At the same time, the Fed is going ahead with Quantitative Easing 2, which will expand the money supply and pump more liquidity into the banks. The policies of fiscal policy austerity and monetary expansion are leading us to the worst of all worlds: declining employment and wages coinciding with rising prices.
At the federal level, the Republicans have proposed cutting $2.5 trillion over the next ten years, while Obama has suggested a spending freeze (not including defense spending) for the next 5 years. Given Obama's propensity for preemptive surrender, the likely outcome of this year's budget fight will include significant cuts in domestic discretionary spending.
The cuts in federal spending will be compounded by cuts at the state and local level. The teachers, cops, firefighters, and other municipal workers who are going to lose their jobs in 2011 do the work that makes our cities decent places to live and work. They also spend the majority of their income in the communities in which they live. Krugman, Baker, and other economists have shown that America is still not producing at anything near full capacity due to insufficient demand. Massive job cuts in the government sector will exacerbate the problem of insufficient demand and push the country back into recession.
It is unlikely that, even when the U.S. economy sinks back into steep recession, policymakers will change course, rehire laid off government workers, and pursue an expansionary fiscal poilicy. Doing so would face insurmountable political obstacles. First, the primary beneficiaries of such an action would be government workers, a group that is largely hated by the elite of both parties.
More importantly, however, is that the financial sector would not benefit from the use of fiscal policy to prevent the U.S. from descending into depression. No large new expenditure of public money that fails to directly benefit the primary financial backers of America's political elite is likely to make it through Congress.
Therefore, when government spending cuts lead us back into recession, the reponse will not be to undo the damn cuts. Instead, politicians will look the Fed to save them. Bernanke will swoop in on his helicopter and shower the banks with money, claiming that it will then trickle down to the rest of the economy. QE2 will be followed by a much larger QE3.
The banks will be flush with cash, as they are allowed to borrow at zero percent, as well as dump their worst investments on Uncle Sam via Fannie, Freddie, AIG and the Fed itself. With the U.S. economy contracting, the big banks aren't likely to invest in American companies. Some will go into gambling in the credit derivitive market, and some will be invested overseas.
The real danger of showering the big banks with cash, however, is that doing so is likely to fuel speculation in the commodities markets. This will drive prices up for everyday necessities like food and fuel at the same time people's incomes are falling. Rising prices for food and fuel will lead to decreased demand in other areas of the economy, such as consumer goods, which will then lead to further lay-offs.
The end result of all this will be increasing stagflation. Fiscal austerity will reduce the amount of money the American people have to spend, while the provision of unlimited cheap money to the big banks drives up prices.
This will continue until one of three things happens:
- Our leaders recognize, acknowledge and decide to rectify their mistakes.
- We replace our leaders.
- America's economic decline leads to the abandonment of the dollar as the global reserve currency, thereby preventing the big banks from being able to use the money given to them by the Fed to buy up commodities or invest overseas.