There are a number of unexploded bombs hidden in the U.S. economy, by no means all of which are George W. Bush's fault, but all of which will have to be dealt with in the next few years.
The bomb for which Bush is most directly responsible, together with the spendthrift and feckless Congress led since 1998 by House Speaker Dennis Hastert, is the Federal budget deficit. Here the problem is only partly the Bush tax cuts, both passed at a time when they looked appropriate to dig the United States out of a mild recession. I would argue that a number of features of those tax cuts, particularly the reduction in dividend taxes, the ending of estate duty and probably the reduction in the top marginal rate of tax, are relatively cheap and so beneficial for the economy that they pay for themselves.
Unfortunately, as with all tax cut bills, the tax cuts for the "rich" had to be paid for with a whole batch of untargeted mass handouts for the poor and the middle class, so the overall bill was much higher than it needed to be. In addition, the Enron-style accounting involved in the tax cuts, and the provision mandated by the notorious Byrd rule that cuts should sunset within 10 years mean that over the next few years the economy is facing either a series of tax rises or further "cuts" that perpetuate the cuts already in place but throw budget forecasts still further out of whack. In particular, the Alternate Minimum Tax in 2005 reverts to its pre-2001 level, which would pull millions more middle income earners into its net; reversing this nonsense alone will cost over $20 billion per annum.
In any case, a greater portion of the deficits has been caused not by tax cuts but by spending increases, partly due to Afghanistan, Iraq and the war on terror, but mostly due to appalling sloppiness and pork-barreling by a nominally Republican controlled Congress, none of which has been vetoed by the President, plus a couple of notoriously expensive boondoggle spending programs instituted by the Bush administration itself. Bush has thus presided over a faster real increase in public spending than any President since Lyndon Johnson, very definitely not the policy on which he was elected.
That's about the end of the bombs for which the Bush administration is directly responsible, but there are several others whose ticking has become too loud to ignore. The Bush administration appears to believe that its tax cuts and spending profligacy will be bailed out by economic growth and the rising tax revenues consequent on it; the other bombs will prevent any such happy circumstance occurring.
First, there's the trade deficit, written about warningly by commentators when it hit $400 billion per annum in 2000, and again when it hit $500 billion per annum in 2002, and now apparently approaching $600 billion per annum. At some point, foreigners will stop buying this enormous quantity of U.S. Treasury bonds, and the dollar will have to decline sharply to bring the deficit back towards balance. Any rapid expansion in the U.S. economy would make the trade deficit worse, and hence precipitate a foreign exchange crisis. While the collapse in the value of the U.S. dollar will benefit exports, its deflationary effect on the rest of the world will be severe, as will the effect of the sharp rise in U.S. interest rates that is likely to accompany it.
The excessive money creation by the U.S. Federal Reserve is also likely to cause a crisis in the near future, this one due to rising inflation. U.S. house prices are currently rising at their fastest rate in 25 years, reducing housing affordability accordingly and inflating a housing bubble larger than that which ended the 1980s. This is both a problem in itself and a signal of further problems to come. Needless to say, a rise in inflation accompanied by a withdrawal of foreign central bank support for the dollar will cause a truly spectacular collapse in the bond markets at some point.
Then there's the stock market, which suffered only a mild dip after the heady heights of 2000, and then recovered. All summer the market has been in "always look on the bright side of life" mode as gloomy economic reports, rising oil prices and declining earnings forecasts have been ignored. At some point this will end, probably suddenly and painfully, and the stock market will drop towards its historical average valuation level, about half where it is now. Since September and October are traditional "market crash" months, this could even happen before the election and affect its outcome, but more likely it will occur in 2005-6. When it happens, there will be a slew of unexpected bankruptcies, mass layoffs, and scandals, all of which will affect the real economy, however unrelated a particular sector may be to the vagaries of Wall Street.
Finally, there's the impending retirement of the baby boomers, scheduled to begin in 2008, but casting an increasing shadow over the financial markets as we approach that date. Bush has promised a reform of the social security system, but such a reform would have been much more easily implemented when he last promised it, four years ago. If he tries to do it now, it is unclear where the $1 trillion that it is estimated to cost would come from. In any case, much more fiscally important than reforming social security is reforming Medicare, a problem that the Bush administration has significantly worsened.
That's about all the unexploded bombs. One problem that will face either Bush or Democrat candidate John Kerry in dealing with them is that their statistical compass, telling them where the economy is today, is off by quite a margin; while they think it points north, as it were, it actually points about west-north-west. As I discussed last week, the implementation of hedonic pricing in the mid 1990s (a piece of numbers-fudging typical of the Bill Clinton administration, as of 90s management generally) has caused reported price index inflation to be understated by about 1 percent per annum, more since 2001 because of record low interest rates and their effect on the housing sector. Consequently, real gross domestic product and productivity gains are both overstated by about the same amount, which doesn't matter much when reported GDP growth is 7.4 percent, as in the third quarter of 2003, but is a lot more significant when reported growth is 2.7 percent, as in the second quarter of 2004.
One of the troubling things about the Bush administration has been the mediocre quality of its economic team, with notably un-cerebral Fortune 500 CEOs as Treasury Secretaries, and no equivalents of Larry Summers (Treasury Secretary under president Bill Clinton) or Martin Feldstein (Council of Economic Advisors chairman under president Ronald Reagan) to provide a grown-up analysis of what's really going on. This is something that Kerry, if elected, needs to change; it's not clear that he knows that.
So we come to the $64,000 question: how will all these problems play out (in what order will the bombs explode?) and what if any difference will be made by the two candidates' economic policies? Here we're into crystal ball time, in which I'm happy to be a journalist, since any prediction longer than a week ahead gets forgotten! Nevertheless, here goes.
If Bush is re-elected, we're due for more of the same. Spending will continue to increase fairly rapidly, but taxes won't, at least at first. Consequently, the loudest explosion is likely to come from the budget deficit, which when it hits $750 billion, 6 percent of GDP, becomes a real problem as it becomes difficult to finance. Inflation is also likely to continue its upsurge, as the Fed is unlikely to raise interest rates quickly enough to quell it. Assuming big problems emerge before the 2006 midterm elections, the latter years of a second Bush term are likely to see a heavily Democrat congress. At that point, the urge to increase taxes will become overwhelming, since Bush will rhetorically be able to blame the Democrats for it. Given Bush's philosophical objection to high marginal income tax rates, and his connections in the oil industry, I would bet on a national Value Added Tax, imposed in 2007. While that would raise huge amounts of revenue, and thereby solve the budget problem, you could then expect a double dip recession (or triple dip, counting 2001) with the 2007-08 down-leg being particularly unpleasant. Reported inflation will be at least in the high single digits by 2008, because of the VAT, but real inflation will be beginning to come under control. Unemployment will be above 8 percent. Social security will remain un-reformed because of the budget difficulties.
If Kerry is elected, you can expect the tax increases up-front, and concentrated in the higher marginal rates of income tax. These increases will yield surprisingly little money; in addition Kerry's protectionism or the fear thereof will cause a downturn in world trade, that may help the trade deficit but will be a drag on the economy as a whole, also hurt by the tax increases. Kerry will try to be reasonably fiscally responsible, so most of his public spending plans won't happen, although there's a chance of an increase in the tax on gasoline later in his term if the world recession causes oil prices to drop and the budget's still a problem. The mid-term elections of 2006 will be an orgy of the blame game, with both sides blaming the other for economic difficulty; a split Congress or a small majority is the likely result. In the second half of Kerry's term, the economy will bottom out and begin to climb back, but from an unemployment level of close to 10 percent at the peak.
Either way, the Dow Jones Industrial Index on election day 2008 will be below 5000.
This is the true choice facing the electorate: between 8 percent unemployment, a triple dip recession, and resurgent inflation, or 10 percent unemployment and a damaged world economy. Either way, government will grow and your income won't.
Of course, nobody is going to tell the voters that...
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2004) -- details can be found on the Web site greatconservatives.com.
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