Paradigm shifts change our economic future

The current emphasis on cutting government spending rather than increasing taxes is a paradigm-shifting event in the United States. If successful this movement, coming on the heels of the Great Recession, will probably push the national economy into a double-dip recession in late 2011.

This paradigm shift is also exposing a rift in the American social fabric. Over several decades, the reduction of marginal tax rates for the wealthiest Americans has widened the income gap for U.S. citizens. Rather than leveling the playing field, it has created a high ridge of the wealthy and a broad plain of middle- and lower-income Americans.

Now state legislatures, specifically in Wisconsin and Ohio, are attacking the bargaining rights of public-sector workers who have traded higher salaries for additional security in their retirement years. The system worked when prices were increasing and the economy was growing but, as in the housing sector, problems appeared when prices fell and the economy contracted. If the government can bail out the banks and the housing industry, it surely has the responsibility to maintain the quantity and quality of government and educational services during recessionary periods.

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In addition to bailouts, the Federal Reserve is pumping unprecedented amounts of liquidity into the monetary system (QE1 and QE2) to keep the banks and the financial sector afloat. Using basic supply-demand curve analysis, we know that this cheapens the value of money, staving off inflation. It actually does little to help lower- and middle-income Americans or protect their jobs.

It does help to clean bank balance sheets of mortgage-backed securities and enhance the value of U.S.-produced goods in foreign markets. Pushing the value of the dollar lower in international markets will expand the export-driven industrial sector in the United States and bring overseas manufacturing facilities back home. It will also make imported goods more expensive and shift their production to U.S. soil.

The Fed claims it can extract this extra liquidity from the financial system when it is no longer needed. I do not believe this claim, but if it happens, it will push the U.S. economy into recession.

Return of stagflation

This financial imbalance is setting our economy up to repeat the stagflation of the 1970s. That was initiated by a four-fold oil price increase, which resulted in price controls imposed by the Nixon administration. When the controls came off, prices exploded.

This was followed by drought-increased food prices in 1974-75 and gas lines caused by persistently higher oil prices. Higher costs, for energy and food in particular, pushed the economy into recession even as prices continued to increase. Higher consumer prices (demand recession) were accompanied by higher energy input costs (supply recession).

Up to this point in 2011, we’ve experienced the demand-side pressures of this scenario as our housing-based wealth has contracted, jobs have disappeared and consumer spending has shrunk. Now we also have several oil-supplying countries in the Middle East and North Africa undergoing governing crises. The instability, enhanced by industrial mistakes in the Gulf of Mexico, is driving up petroleum prices. Capital in the energy sector is rapidly flowing into developing natural gas production, putting additional pressure on input costs as the industrial sector makes this structural shift.

So, we’re merging demand-side consumer spending impacts on our economy with supply-side cost increases caused by higher petroleum prices and structural shifts in energy usage. Throw in higher food prices and this is almost an exact repeat of the late 1970s when stagflation reigned.

Japan and China are currently funding our deficit as the predominant purchasers of our Treasury securities, but Japan has its own problems as a result of the earthquake, tsunami and nuclear crisis. Growth in China’s economy is slowing, its currency must increase in value which will make exports more expensive, and the country must develop its own energy independence. They may not have as much cash to invest in Treasuries as in the recent past.

The Fed, to entice Americans to begin buying Treasuries, will soon have to increase interest rates. I don’t think the rates will reach the 14 percent of the late 1970s but they definitely are going up, and probably enough to cause a recession. I think it may happen by late 2012 but perhaps not that soon.

We’ve dug ourselves a big hole and a lot of people are going to have sore muscles and a strained back before we get out of it.

John W. Green is a regional economist who compiles the Northern Colorado Business Report’s Index of Leading Economic Indicators. He can be reached at jwgreen@frii.com.