Saturday, July 09, 2011

 

Cuts in government spending will likely trigger economic collapse

Congressional Republicans got the message. Raising taxes would be suicidal politically for them.

The fiscal path the country is on will take us to an unprecedented level of spending and taxation. Why should the Republicans want to facilitate this process any more? It is contrary to pretty much everything the party is supposed to stand for. If anything, the GOP earns a fair share of the blame for this impending disaster because the party didn't do anything about it between 2003 and 2007, when it had full control of the government and knew full well that, thanks to the baby boomers and out-of-control medical costs, our terribly outdated Medicare system was set to blow up the budget. At least now, Republicans are no longer a party to making it worse, by demanding -- at last! -- some fiscal restraint and some sensible reforms.

That means there is only one way to get control of debt-- spending cuts. And that will be a problem for the economy. You see, it has been government spending which has been propping up the economy, preventing deflations full force from being felt. (How's that for alliteration?)

Everything is very fluid, but the headlines in today’s Wall Street Journal suggest a deal on the order of $4 trillion in on the table. I assume it will be back-loaded, but it is a start. But assume that the first year sees real spending cuts of $200 billion. That is a reduction of 1.5% in GDP. It’s that pesky old equation I keep using:

GDP = C (total consumption) + I (Investments) + G (government Spending) + net exports

Now, the literature suggests that the effect on the economy from a reduction in G should be over within about 4 quarters, on average. But then we reduce “G” again the next year. Maybe not by as much overall, but at least by another $50-100 billion. This is going to put a real headwind in the face of economic growth for years, but we simply have to do it or we become Greece.

The economy will already be slowing down. A recession in 2012 is a real possibility if there is any type of shock coming from Europe, and what will happen there is anyone’s guess. I think most European leaders are basing their thinking more on hope than on reality. When Greece defaults there will be a domino effect; you can count on it. And you could actually see a banking crisis before we get actual sovereign defaults.

So any cuts in government spending along with the Federal Reserve ending it's monetizing our debt will hurt in the short term. Everyone in government knows this but they can't say it. Deflation was always going to win. Take a good look at Japan to see a country that tried to borrow its way out of deflation. It didn't work. It won't work here. We just have to take our medicine and that will mean at least a few more years of pain. Also, remember that the stock market rally since 2009 was entirely paid for with stimulus money that will be going away soon.


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