The coming year will demand two major changes in Washington: 1) The Federal Reserve will need to absorb excess reserves from the banking system or risk igniting inflation. 2) The White House will need to slow the tide of deficit spending or risk undermining the dollar’s role as the world’s reserve currency.
The Federal Reserve (Fed) knows that past liquidity injections require a response. Though done to relieve the strains of the financial crisis, the excess of money and reserves in the banking system, unless removed, just about guarantees inflation — too much money chasing too few goods. And the rise in such inflationary pressure has been dramatic. During the past year, bank reserves have increased by an astounding 225 percent, the monetary base — bank reserves plus currency in circulation — has jumped by 77 percent, and the primary, M1 measure of money supply has increased by 13.5 percent. All these expansions are far beyond the economy’s longer-term fundamental needs, which at most would require money growth of 6-7 percent a year. Little wonder, then, in the face of this inflationary prospect, that the price of gold has skyrocketed by some 30 percent since the most intense fears about the economy began to ebb last July.
Though many of the programs that the Fed put in place to alleviate the financial crisis have begun to shrink naturally as financial healing relieved the need for such assistance, ultimately the needed remedial action will demand a rise in short-term interest rates. Since such rates today are inordinately low, the economy, especially as the recovery gains momentum, will cope will with moderate rate hikes, but the political pressure on Fed chairman Bernanke to delay the needed move will nonetheless build as the 2010 election approaches. If he and the Fed yield to that pressure, then inflation concerns will build, gold prices will continue to rise, and the dollar will continue to lose value on foreign exchange markets. If the Fed resists such pressure and steps up to its responsibilities, it can forestall such painful outcomes.
Demands for a change in White House budget policy are no less important. The budget outlook presently is far from encouraging. Fiscal 2009, which ended this past September, had a deficit of $1.4 trillion, more than three times the $459 billion deficit of the previous year. At 10 percent of the gross domestic product (GDP), last year’s flow of red ink was almost twice the size of Ronald Reagan’s worst relative deficits and unprecedented since World War II. Official White House estimates for the current fiscal year show only a slight improvement to a deficit of $1.3 trillion. At 8.5 percent of that year’s estimated GDP, the situation would be the most severe since 1945, except, of course, for last year.
Weighing even heavier than this immediate situation are projections of continued large deficits for 2011 and beyond. According to White House estimates, these remain large despite expectations of continued economic recovery. Even out in 2013, the White House looks for deficits of over $500 billion, still substantial at over 3 percent of projected GDP. What is more, these rather depressing expectations emerge even amid unrealistically optimistic expectations for economic growth. More plausible growth figures would constrain revenues expectations and generate still larger deficit estimates.
Even more problematic are the uncertainties engendered by the administration’s heavy legislative calendar. Two issues in particular feature large, health care reform and the cap-and-trade environmental bill. Neither is included in the administration’s already large deficit estimates. The second of these pieces of legislation would actually tend to narrow the deficit because it amounts to a huge tax on production. But there is reason to worry over its economic effects anyway, as it would raise costs throughout the economy and hamstring growth accordingly. The health care picture is more ambiguous. The Congressional Budget Office (CBO) has characterized both bills before congress as deficit narrowing, despite the huge costs involved, under the dubious assumption that business will pay out any health care savings in wages and in so doing raise incomes and income tax receipts. Though plausible, such a view nonetheless leaves much room for skepticism.
What the economy needs in this situation is first an end to the huge legislative uncertainly and second a believable plan to contain the deficits and the flow of debt. That plan must include specifics. So far, various elements in the government have expressed determination to establish prudent budgetary control, but has offered more than the vaguest of statements along the lines of bending the government’s “cost curve,” what ever that could mean. If Washington wants to move the economy forward, it will have to give confidence that it has a definite plan. Further, that plan will have to address deficits with something more than just tax hikes, which will have their own adverse economic consequences. They will have to address spending, particularly entitlements spending, which already constitutes more than half of all federal outlays, far larger than defense spending.
At the moment, citizens have the luxury of time. The economic recovery is just beginning and these needs can wait for some months yet. But as 2010 matures and the recovery gains momentum, further gains will demand these policy changes. The authorities at the Fed and the White House do not have to do everything right, but they will have to make some change in these directions or the longer-term prospects for the economy, inflation, and the dollar will darken.
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