As we begin 2010, the daily news reports tell us that the economy is on the mend and indicators are suggesting that the recession is ending. In many ways, things just seem better than at the beginning of 2009. The stock market has stabilized and rebounded. Reports tell us fewer people are losing their jobs. Other reports tell us that the economy is in the early stages of a recovery. U.S. manufacturing posts modest gains.

By now, we have adjusted our expectations for the future downward and reduced our spending. And the shock of the economic meltdown which we felt so keenly in January 2009 has diminished. But it is really smooth sailing ahead? Or time to batten down the hatches?

Fundamental trends are under way that could create the perfect storm for further economic disaster starting as early as 2011. Just like the weather cataclysm in the book and movie "The Perfect Storm" that wrecked the fishing boat and killed all on board, these trends threaten an economic downturn much worse than we have already suffered.

Four major trends crest in 2011 which threaten to drown chances of a real recovery. First, taxes. Additional tax increases are expected to go into effect in 2011 to support health care overhaul. And the Bush tax cuts will end at the start of 2011 under budget policies already adopted by the Obama administration. After these changes, the top income tax rate including state taxes would average 52% across America.

That top U.S. income tax rate would be higher than in France, Germany, Canada, and 23 other countries in the OECD. In 5 states dominated by Democrats--California, New York, New Jersey, Hawaii, and Oregon--the total top tax rate will be higher than in socialist Sweden.

Moreover, the top capital gains tax rate would soar by 66%, from 15% today to over 25%. The individual income tax on corporate dividends would also increase substantially. These increases will stifle investment, entrepreneurship, small business start-ups, business expansion, new jobs, wage and income growth, and overall economic recovery.

The second factor affecting the economy in 2011 is rebound unemployment as stimulus spending declines. Whether or not the stimulus has been effective in preserving and creating jobs, even the Obama administration says that the effects of the stimulus spending will have peaked by mid-2010. Indeed, stimulus spending will likely produce a negative feedback effect on the economy by 2011. This is because every dollar in Keynesian stimulus spending takes an estimated $1.23 out of future GDP, according to many economists. Additional stimulus spending by Congress—like “Cash-for-Clunkers” may extend phantom job creation a bit longer, but would still produce negative effects as soon as it is spent out.

Once the stimulus money is used up, state and local governments that used the funds to plug holes in their general operating budgets will have to cut back jobs or raise taxes substantially. And since most jurisdictions used the money to support levels of spending that were too high to begin with--rather than to build additional infrastructure, all that spending will not have increased American productivity much. Yet, we will still be paying the bill for today’s stimulus spending in the future, with higher interest costs and a larger tax burden.

A similar effect will result from the Census Bureau hiring up to one million workers for the 2010 Census. Expect the unemployment rate to go up another 3 or 4 tenths of a percent when those same workers are laid off in 2011.

The third trend that will crest in 2011 is inflation—from a combination of our weak dollar policy and our huge deficits. The dollar’s decline reflects incredibly loose Fed monetary policy, as the Fed expanded the money supply while maintaining record low interest rates near zero. In addition, federal debt will exceed 100% of GDP by 2011, leaving us with the 7th highest government debt-to-GDP ratio in the world, in company with countries such as Zimbabwe, Jamaica, and Lebanon. That will produce further dollar declines, and further increasing inflation.

Lastly, if Congress passes any of the expensive legislation that it is contemplating, the resulting costs will be the fourth and final cause of the perfect storm. Cap-and-trade, health care, and pro-union legislation like “card check” would all result in huge expenditures and inefficiencies that the American people will be forced to bear--starting mostly in 2011. And in the case of cap-and-trade, energy production will be sharply constricted, and energy costs will rise--further contributing to inflation, while killing still more jobs and creating still more misery.

The perfect storm in 2011 may bring us double digit inflation, soaring interest rates, record unemployment and a worsening recession. Prepare yourselves.

3 Answers

  • Yakuza
    Lv 7
    1 decade ago
    Favorite Answer

    Indeed, one could argue (and some policymakers do argue) that the most natural sequencing would be to tighten the fiscal stance and the Fed’s balance sheet policies before raising the funds rate. Large-scale fiscal stimulus and Fed asset purchases were only adopted as emergency measures after the funds rate had hit the zero lower bound. Both policies can be thought of as attempts to get closer to the negative funds rate prescription of Exhibit 1. If and when this prescription changes—i.e. if and when the Taylor rate moves back toward zero the logical first step might be to unwind these fiscal and balance sheet policies before raising the funds rate, especially given the structural imbalance of the federal budget and the markets’ hypersensitivity (misplaced, we believe) about the inflationary implications of a bloated central bank balance sheet.

    It would be a mistake to take this “sequencing” argument too far. On the fiscal side, it will be difficult politically to actively tighten policy, i.e., raise taxes or cut spending at a time when the unemployment rate is around 10%. On the balance sheet side, only a minority of Fed officials seem to favor outright asset sales. Others worry, in our view correctly, that it may be difficult to calibrate the effects of such sales on financial conditions and would prefer hikes in the funds rate to precede outright asset sales.

    But a softer version of the sequencing argument may still apply. Even if there is no turn to active restraint via tax hikes, spending cuts, or asset sales, it is highly likely that there will be some passive restraint. Exhibit 2 shows that we expect fiscal policy to turn from stimulus by late 2010 or early 2011. Moreover, the asset purchase program is likely to be completed in the first quarter of 2010, and this might lead to a tightening of financial conditions if the “flow” of purchases matters for either the level of long-term yields or the valuation of other assets. The larger these passive restraints, the further away is the point at which Fed officials will need to turn to federal funds rate hikes to in order to fend off inflationary pressures

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  • 1 decade ago

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