The New Stagflation

Editor's Note: This piece is from the Washington Monthly's series of 16 predictions on the likely consequences of a second term for President Bush.

Next year's economic difficulties are already on the horizon. Growth is slowing as the housing market cools and consumers rein in their spending. Inflation is rising a bit, driven mainly by oil prices, health care costs, and corporate price increases, fueling a spectacular recent profit surge. Job creation is weak, and wages are flat. This is the new stagflation – an unpleasant reminder of the economic cost of unilateral war.

But George W. Bush has never tried to fix the economy in the short term. His focus is on making long-term – and, he hopes, irreversible – changes to taxes and social programs; foreign policy; and the government's capacity to regulate the environment, natural resource use, and corporate behavior.

Bush's top economic priority has always been to cut taxes on the wealthy; as he famously said, the "have-mores" are his political base. The marginal income-tax rate, the estate tax, the tax on dividends, and the proceeds of the profits tax all fell sharply in his first term. His second term could finish the job, shifting the tax base to consumption, perhaps even abolishing the income tax for a value-added tax (as Republican Speaker Dennis Hastert now suggests). Virtually the whole tax burden will then fall on the middle class, on working Americans, and on the poor.

As revenues fall, spending programs will come under new attack. But not defense spending: The Pentagon's budget will remain inviolate. Indeed, the military may demand still more spending, as the true costs of stabilizing Iraq gradually become clear. New arms races – with North Korea over missiles and missile defense – and new conflicts, perhaps with Iran or China, may come into view. We will need many more soldiers and much more money if such conflicts occur. And so, given the budget deficits ahead, the battle royal will be fought over what remains of federal social spending. With Alan Greenspan at his side, Bush will challenge Congress to slice, dice, and eviscerate. The privatization of Social Security – an invisible issue right now – will surely resurface once the votes are safely cast in November.

Meanwhile Greenspan will try to steer between a cost-driven price inflation and a sagging labor market. Should he raise interest rates or hold the line? The Fed started boosting rates just before the recent spate of bad economic news revealed slower growth, weak job gains, slumping consumer spending, and falling producer prices. This shows that its insight into our present problems isn't deep.

Indeed, the Fed is driving blind. Greenspan is aiming for a "natural interest rate" – a hypothetically neutral interest rate that would neither stimulate nor retard growth or inflation – whose value, as he admits, he doesn't know. How this idea came to dominate Fed thinking isn't clear: The concept is a throwback to the economics of a century ago and is the basis of almost no modern research. But we do know that higher interest rates will mean more pressure on debt-ridden households, slower consumer spending growth, and stagnant or falling stock prices – as anyone can see.

Bush's second term may see a crisis of the dollar, now heavily reliant on reserve-asset stockpiling by China and Japan, which own a huge proportion of our debt paper. In effect, those countries are sending us cheap goods in return for expensive paper, working hard for no current material reward. Will they continue this odd behavior for four more years, even if tensions erupt over Korea or Taiwan? Or will China, especially, diversify into euros, or perhaps into commodities, aggravating global inflation? Will the neglected states of Latin America, increasingly alienated from the United States, set off a banking crisis with debt defaults? We'll see. The dangers are real, and we are totally unprepared.