Tough Times Ahead: Gridlock and Quantitative Easing Are Not Enough

Now that the elections are over, attention is turning to the economy.

The stock market rose steadily from the end of August up to the elections. Since the stock market tends to be forward-looking, its recent strong and steady rise suggests that investors have been optimistic. In my opinion, two factors have generated that optimism:

1) The expectation that significant Republican gains in Congress would produce political gridlock, thereby putting the brakes on the Obama/Pelosi/Reid/progressive spending binge.

2) The Federal Reserve’s promise of “QE2,” a second round of “quantitative easing,” the currently fashionable euphemism for creating mind-boggling sums of new money out of thin air.

Sorry to rain on anyone’s parade, but I don’t believe that gridlock (assuming it happens) and QE2 will be sufficient to turn the economy around. There are several reasons for my tepid outlook.

Surely, gridlock—a political stalemate between the Democratic president and congressional Republicans—will change the game. There will be no more enormously expensive and economically crippling legislation, like the mega-non-stimulus and healthcare/insurance reforms that were passed, or the cap-and-trade monstrosity that was barely averted.

To use a medical metaphor, compare the economy to a human body that has been bludgeoned. Obviously, it helps when the bludgeoning stops. But just because additional blows aren’t being struck, it doesn’t mean the patient is healthy; the patient is still at risk from internal injuries. Our economy urgently needs a trip to the emergency room for radical surgery and intensive care. The government needs to undo the massive damage it has inflicted on the economy over the last several years. It needs to reverse, not merely halt, runaway spending, and to shrink, not just slow, the growth of the federal bureaucracy.

Recently, the Congressional Budget Office released a study projecting total federal spending of $44.5 trillion during this decade. Since we are already choking on $3.7 trillion of spending this year, the implication is that Uncle Sam is on track to spend over $5 trillion in other years later this decade. Will the new Congress, even with the addition of several dozen fiscal conservatives, be able to overcome Obama’s resistance to canceling trillions of dollars of planned spending? I doubt it.

Those longing for a return to the economic good times of the 1990s by replicating the gridlock that existed between the Clinton White House and Gingrich Congress need to realize that circumstances are significantly different today. Gridlock tends to preserve the status quo. That was desirable in the mid-90s, when the economy was healthy and growing; preserving today’s economic stagnation, by contrast, is not desirable. It is unacceptable.

Even if Obama and the new Congress surprise us by reducing the annual rate of growth of federal spending to the modest 2.9 percent level that Clinton and Gingrich achieved (highly unlikely, given Obama’s ideology), the ticking time bomb of Social Security, Medicare, and Medicaid’s unfunded liabilities will continue to push us inexorably onward toward ruin.

At any time, the world’s bond investors may demand a higher interest rate to compensate for the risk of insolvency. That would cause the cost of financing our trillions of dollars of debt to soar, consuming hundreds of billions of dollars of tax revenues.

The see-no-evil optimists would say, “Hey, why worry? The Fed will buy all those bonds.” That’s the purpose of QE2.

The problem here is that bond investors will still demand a higher interest rate to compensate them for the cheapening of the dollar (what we call an “inflation premium”) that will inevitably result from the Fed creating so many new dollars to buy the Treasury’s debt. In anticipation of QE2, major bond-buyers—notably the Chinese and PIMCO, the largest American bond fund—have already started to sell Uncle Sam’s bonds. I wouldn’t want to bet against PIMCO chief Bill Gross, who is to bonds what Warren Buffett is to stocks. If the exit from bonds becomes a stampede, Katy, bar the door, because QE2 may then go to infinity, as in “hyperinflation.” Adios, greenback!

Ben Bernanke has to know that QE2 cannot possibly produce prosperity. QE2 is another instance of “the money illusion” that all Econ 101 students (at Grove City College, at least) learn: Money isn’t wealth, and even if the central bank created a million dollars for every single American, we wouldn’t be any richer in real terms.

Yes, it’s possible that a flood of new dollars may buoy stock prices, but in terms of real wealth and real jobs for Americans in general, lots of luck. Those pinning their hopes for a vigorous economic turnaround on political gridlock and QE2 are likely to be sorely disappointed.