Don't Bet On A Soft Landing Into The New Normal

With the recent financial crisis, Mohammad El Erian of Pimco has predicted a 'new normal,' categorized by 1-2% economic growth (instead of close to 3%), tightened lending, and more government.

The basis of these predictions are fairly sound. With increased government and taxes, we can expect rates of growth similar to those in Europe and Japan, which are about 1%. This is because the government is more inefficient than the private sector, and more resources are devoted to the government than to businesses.

I agree with a lot of this analysis, but I think the economic and political situation will be more volatile than this. If our politicians really wish for our economy to mimic a Western European social state, then the average standard of living still has about 25-30% to drop off. This would match the average GDP per capita of most Western European states. When you count in the fact that our country is burdened with a drug war, large military, and more debt, you may expect even worse...though our country's labor system is much more flexible than those countries (and will be even if bills like Card Check pass).

With all that is going on, I do not see us soft landing into this new normal, just like we didn't soft land into the recession. What will be the switch that causes a massive drop, similar to how Lehman Brothers's collapse sparked the fall meltdown, is not clear. It may be the actual tax increases going through, but I remain skeptical this will even occur.

More likely, I believe it will be some sort of inflation, since this is a hidden tax that cannot be controlled. What I see from Obama and the Democrats is a steadfast optimism and blindness to the budget deficit. They always expect far more taxes to be raised from tax increases, far less spending to be done, far more economic growth than is possible, and far more efficiencies resulting from legislation than could happen. The combination results in these highly optimistic budget projections that only a fool would trust.

Thus, I believe we will run deficits far exceeding what the administration expects. At some point, bondholders will get worried and demand higher rates. The explosion in interests rates may cause another economic downturn, or the Fed may step in and print money resulting in inflation. Either way, I don't think we will crash due to higher taxes. The deficit may be the trigger, but it will be the effects of it, eitehr high interests rates or inflation, that will be the ultimate weapon of calamity.