Updated at 2:48 p.m. on Aug. 18.

Deficits are looming large going forward and for the first time we are at risk of reaching unsustainable levels, meaning levels that will require inflationary monetization. The underlying problem results from a combination of three factors: (1) a lack of any progress in reining in the costs of Medicare and Social Security over the past decade and no apparent political will to implement reforms now, (2) an acceleration in on-balance sheet government spending, which began under the Bush Administration and is increasing under the current Administration, and (3) anti-growth policies of the Obama Adminstration and Congress that will slow economic growth and thus make it harder to avoid monetization for any given amount of deficits in the future (these policies include rising income tax rates, carbon taxes, risks of further tax increases in support of healthcare coverage expansion, and anti-free trade policies). The actual inflationary consequences of this horrible mix of policies will not become apparent for several years, by which point it will be extremely painful to prevent inflation from rising.

There can be little doubt that the loss of control over the US public finances poses a real long-run risk of high interest rates and high inflation that in turn could reduce the US economy’s longer run growth potential. This is particularly the case when one considers the very high degree to which the US government deficit is financed from abroad, which exposes the country to the risk of a dollar crisis. For this reason, one has to regret that the Obama Administration is yet to spell out in a credible manner how the US public finances are to be placed on a more sustainable medium-term basis.

The long-run US fiscal outlook must give rise for serious concern about how the government will crowd out private investment once the economy fully recovers. On evaluating the 2009 budget, the Congressional Budget Office estimated that on present policies, the US public debt would approximately double from around 40 percent of GDP in 2008 to over 80 percent of GDP by 2019. The CBO also estimated that, even once the economy fully recovered, the government deficit would remain in the range of between 4 percent and 6 percent of GDP.

While prospectively very large budget deficits pose clear long-run inflation risks to the US economy, in the immediate term those risks would seem of a very much lesser order. Indeed, it would seem that the very weak economic recovery in prospect and the very large gaps that will continue to characterize the labor and output markets for some time will keep downward pressure on inflation and will keep interest rates in check.

In the immediate term, one has to expect an unusually weak US economic recovery. The presently large gaps in the labor market are bound to severely constrain household income growth while attempts by households to repair damaged balance sheets will cause the savings rate to continue to rise to a more normal level. In the absence of meaningful consumption growth, it is difficult to see how the US gets an overall economic recovery of any strength or how unemployment comes down from its presently high level.

The weakness of the US economic recovery in the period immediately ahead is bound to give rise to calls for a second stimulus package that would further compromise the US public finances. One must hope that if the Administration does need to introduce a second fiscal stimulus package, it does so in a more targeted and thoughtful way than it did the first time around. One must also hope that it does so in conjunction with a clearly articulated and credible medium-term budget program that includes specific commitments to bring the US public finances back under control within a reasonable time-frame. Failing that, the Administration should not be surprised by negative reactions in the US bond market and on the foreign currency exchanges that could further complicate economic recovery prospects.

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I doubt that the deficit will be a serious drag on the recovery. The Treasury hasn’t had much difficulty selling its debt so far and interest rates remain at reasonable levels. In addition, even if the economy starts moving in the right direction, it will likely remain depressed for several years, limiting the demand for credit from the private sector. And if the recovery is short-lived or falters, then another stimulus could be needed and should not be held hostage to concerns about short-term deficits. That said, it’s important to get a handle on the long-term fiscal situation since it could at some point produce a serious problem in the form of higher interest rates, a plunging dollar, or a foreign policy complicated by the need to assuage the concerns of other countries about our massive borrowing. Right now, the prospects for dealing with the long-term problem look grim. All three of the likely solutions are stalled or off the table: Social Security reform, tax increases beyond those needed to pay for expanded health insurance coverage, and health care reforms that will seriously bend the longer-term health cost curve.

If the stock market is signaling a possible recovery the question is why? What changed. The “stimulus spending” bill was passed in February and employment and the stock market fell. What has changed in the past two months is the political health and clout of the Obama administration. It is now less likely that taxes will be placed on energy in “Cap and Trade” and less likely that grave damage will be done to the drug industry. This is good news for the economy and the market has risen as a result.

This is what happened back in 1994 when the Republicans captured the House and Senate and the stock market began its bull market. The market did not wait for the cap gains tax cut or welfare reform…it began to move up upon learning the Rs were in charge. The economy began falling apart after the Dems took the House and Senate and sped up when it became clear they would have the White House as well.

If you want to know where the market is going….check Obama’s popularity and the polling data on the generic R vs. D polling. The worse the Dems do, the better the market will do. So real, sustainable, bull market until the Republicans capture the House and drop the Dems below 60 in the Senate.

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The huge and ongoing federal budget deficits are the elephants in our economic room that eventually cannot be ignored. Fortunately, in the short run – and that means through 2010 – the economy is sufficiently far from full employment that the deficit should not significantly impinge upon the recovery. But as GDP gets closer to potential GDP, sometime in 2011 and/or 2012, if the long-run structural deficit is not brought down in a meaningful way, then government borrowing surely will begin to crowd out private investment and send interest rates up. How far up will depend, of course, as it has on the past, on the willingness of foreigners to keep funding our profligacy. But foreign patience eventually will wear thin, in my view. The US thus courts another even larger recession, with few tools to get us out, if the deficit is not tackled. Right now, I am not optimistic. I hope our political leaders somehow someway eventually (sooner rather than later) prove my worries unfounded.

The most recent CBO forecast predicts a deficit next year of $1.43 trillion, or a bit less than 10% of expected GDP. While this seems like a shockingly big number, it is unlikely to pose an appreciable risk to the recovery. On the contrary, the tax and spending policies that cause the deficit are providing much of the stimulus that has limited the severity of the recession and given us the prospect of economic expansion this year and next.

The usual argument against big government deficits is that they boost interest rates and cut the flow of savings into private investment. Falling private investment is certainly an important reason for current economic weakness. In quantity terms investment has fallen almost one-third since 2007.

Business investment hasn’t shrunk because of high interest rates or too much government borrowing, however. It has dropped because private companies see little demand for the goods and services they can already produce. If factories, retail outlets, and shipping companies have vastly more capacity than they need to serve customers’ demand, there is no rationale for them to make investments that will expand existing capacity. When house prices are tumbling and local markets have tens of thousands of vacant homes and apartments, developers have little reason to add to the glut by building new ones.

Government borrowing is not impinging on investors’ access to borrowed funds. In fact, extraordinary actions by the national government and Federal Reserve have kept credit flowing to businesses and consumers in the face of a severe financial crisis. Weak private demand has reduced the need for businesses to expand or even to maintain their existing capacity, and this is likely to remain true for the next couple of years. The federal government has plenty of scope to maintain the stimulus programs already in place and to expand the programs if weak private demand should threaten to derail the recovery.

When private demand recovers there will be a powerful case for reducing the public deficit. Can we count on Congress to accomplish this task? In politics there are no guarantees. It requires political courage for legislators to reduce the growth in spending and to hike taxes. While it is relatively easy for opponents to mobilize public sentiment against tax increases or spending cuts, it is much harder for budget analysts and public officials to make a persuasive case that these measures will benefit voters in the long run.

In spite of the difficulties, legislatures in most major democracies, including this one, have eventually faced up to their responsibilities. Public spending has not spiraled out of control; taxes have not fallen to zero; the burden of government debt has not become unsustainable. A betting man would put his money on the proposition that Congress will do the right thing . . . eventually.

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