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As negotiations are raging in Washington over a $33 billion compromise on  spending cuts for the 2011 Budget, we discuss the economic and political risk that the President and Democrats in Congress are willing to assume by caving in to Republican demands for deep spending cuts. This diary entry is in two parts.  In Part I we address the risk to economic recovery: a double-dip recession that will keep unemployment high, wages stagnant, house prices falling, number of foreclosures increasing, and will worsen the deteriorating conditions of the middle class, workers and the poor. In Part II we address the political ramifications: the risk of diminishing President Obama's re-election chances, further alienation of key Democratic constituencies, and further disillusionment of the most active and progressive elements of the Democratic Party, as well as the President's strategy to counter these trends now and during the forthcoming major battles for the 2012 Budget and Entitlement Reform.

Current Status of Budget Negotiations

In two installments, one for $4 billion and another for $6 billion, a total of $10 billion in spending cuts have been agreed so far by both House and Senate and signed by the President. These stopgap spending bills enabled the Government to operate and the debt ceiling extended till April 8.  Moreover the President in his budget proposal had proposed another $40 billion in cuts by freezing discretionary spending below what was the expected 2011 budget baseline (the savings would be $400 billion over 10 years and would bring the budget deficit to 3% of GDP by 2015; spending cuts as well raising taxes is part of this mix after 2012).

Negotiations are now underway for another $23 billion in cuts to a total of $33 billion in cuts out of the $61 billion that the GOP-controlled house voted and a total of just above $70 billion from the initial 2011 budget baseline.  For a comparison of GOP's and the President' s Budget Proposals and a discussion of the politics of the Government Shutdown up to this point, please refer to my Daily Kos post of March 16: "Rival Fiscal Agendas Threaten Government Shutdown" (click here: refer1) and my Erie Times News Op-Ed of March 5: "Democratic, Republican Outlooks Illustrate Polar Opposites" (click here: refer2).

It seems that though there may be agreement in principle on the $33 billion figure (for total spending cuts), two factors threaten it and present serious obstacles to closing the final deal: (i) Tea Party pressure on the 87 Republican House freshmen to insist to the full $61 billion and (ii) the 67 "policy riders" (highly partisan amendments aiming to appeal to extreme social conservatives) added by these freshmen to the cuts in the GOP House Bill passed in early February 2011, these together with some  similar "riders" in the initial $61 billion in cuts are unacceptable to Democrats.

Compromise Cuts Still Threaten to Derail the Economic Recovery

Almost 8 million jobs were lost during the Great Recession of 2008-2009.  So far more than 600,000 private sector jobs have been added by the economy in 2011, another 1.1 million such jobs in 2010 -- the Stimulus most likely saved or created another 2 to 2.5 million of jobs in 2009-2010.  But the states have lost around 60,000 jobs so far in 2011, in addition to the 330,000 jobs lost in 2009-2010 -- despite the $300 billion assistance to the States (1/3 of the 2009 Stimulus Act).  The unemployment rate is down to 8.8% from a peak of 10.1% in October of 2009; it was 7.8% when President Obama took office.

But we still have 13 million unemployed and there are 5 persons seeking for a job for each person finding one. We need 125,000 new jobs per month to keep up with population growth, and because of the millions of jobs lost in 2008-2009, even at a rate of 200,000 new jobs per month, we will not get back to 6% unemployment until 2016.  The economy is projected to grow at a potential rate of 2.5 - 2.75% by most estimates with a max rate of 3.25 % being an optimistic outlier. But we would need 4% to 6% growth rate, if we were going to get back on track soon (say by summer 2012), as we did in other more shallow recessions (like in 1983-4 and 1995-6).

It would seem that the economic recovery is picking up steam but there are several factors that may affect it adversely.  First the international situation: the effects of tsunami and nuclear disaster in Japan that may slow that economy significantly (at least in the short term), the continuing problems with sovereign debt and big banks in Europe, as well as the austerity government programs in some European countries, also the uncertainty and unrest in the Middle East with the ongoing revolutions in the oil-rich Arab world, and the rising cost of oil and gas due to increasing world demand, all could potentially slow the global economy.  

And then come the domestic problems. First, the Federal Reserve will keep the interest rates near zero till the growth rate picks up and the unemployment rate falls significantly, but low interest rates alone will not do.  The Fed will complete its QE2 (quantitative easing -- printing money to buy Treasury Bills, or monetizing the debt -- in June 2011) and then it may start withdrawing some of the monetary surplus. The Stimulus of 2009-2010 is over with very few infrastructure projects continuing in 2011; this also pertains to the assistance to the states ($300 billion from the Stimulus).  Indeed, state and local governments around the country will be slashing their budgets by roughly $110 billion in 2011; this may shed more than 150,000 state jobs this year.

We must not forget that the Tax-Cut Compromise of Dec 2010, enacted some stimulative measures to help the economic recovery: (i) extension of the Bush tax cuts for the middle class and relief from alternative minimum tax, as well as the Bush tax cuts for the wealthy and lower estate taxes, (ii) accelerated expensing of equipment and software investments and R&D tax credits, (iii) payroll tax deduction from 6.2% to 4.2%, and (iii) earned income tax credit, child and college tax credits for low income earners. From these, item (i) expires in Dec 2012 but items (ii), (iii) and (iv) expire in Dec 2011; so this short-term stimulus to the economy will be absent in 2012, or they may have to be renegotiated with the Republicans to an uncertain en.

To the above we must add the cost to the economy that $33 billion of federal discretionary spending cuts will incur. Wall St' s investment firm Goldman Sachs and rating firm Moody's estimate that GOP spending cuts in the range of $75 to $200 billion for the years 2011-12 will cost the loss of 700,000 to 2 million jobs. Thus, it is reasonable to estimate that at least 300,000 jobs will be lost in 2011 alone due to $33 billion in such cuts. If we add to these the jobs that will be lost to the states due to their budget shortfalls and belt tightening, we are looking at 350,000 to 450,000 jobs lost in 2011 due to combined federal and state government spending cuts.

Moreover, housing market problems persist, house prices are falling and the number of foreclosures increasing as the Affordable Loan Modification Act (and the $50 billion set aside for it from TARP) did little to help -- due to the Banks' intrasigence and their preference to proceed with foreclosures rather than loan modifications for most of the problematic mortgages.  Defunding the Financial Consumer Protection Bureau, as the Republicans want, will not help this already dire situation.  

Since Obama's proposed cut-and-invest fiscal agenda (click here: refer2) that included some pro-growth investments is now wishful thinking (due to a total of $70 billion in cuts on initial baseline budget), the only hope for additional economic stimulus (besides the aforementioned stimulative measures of the Tax-Cut Compromise) is the Federal Reserve. Quantitative easing beyond June 2011 (QE3 ?) would be desirable but is unlikely, given the rising food, fuel, and other commodity (industrial and precious metal) prices.  Though for the most part these are due to increasing global demand, the potential of further currency devaluation due to additional quantitative easing will scare the Fed from enacting any additional easing.  If anything, core inflation (this excludes food, fuel and other commodities) will hopefully  remain low so that the current low interest rates can be maintained.

Yet another issue that keeps consumer demand weak (if not anemic), and thus denies the recovery its most important stimulus, is the stagnation of wages and the skewed wealth distribution.  Actually, the expected layoffs of many college-educated, experienced state and government workers due to the aforementioned budget cuts will suppress wages further by enlarging the pool of qualified, desperate white collar workers looking for work. This is a side effect of the conservative theory behind the GOP spending cuts: the delusion that spending cuts will grow the economy; the so called "Mellon Doctrine" discussed in detail in the recent Op-Ed by Paul Krugman in The New York Times of March 31 (click here: refer3).  As for the over-concentration of wealth in the hands of few and the diminishing buying power of the middle class, several studies by Economic Policy Institute and others have established its validity; a good reference for some aggregate results is provided in the Mother Jones article :"Income Inequality In America" (click here: refer4) and series about Income Inequality.

Finally, another reason for lack of optimism about the strength of the recovery is the continuing off-shoring of jobs by big corporations and multinationals (despite the $2 trillion cash in their balance sheets) which is coupled with their increasing dividends and carrying out stock buybacks and mergers and acquisitions, instead of investing in plants and new jobs on American soil.  Without (i) new industrial policies that discourage the outsourcing of jobs overseas and (ii) reforms in the corporate tax law that eliminate excessive or nonessential subsidies and tax credits, and close tax loopholes that enable deferment of tax payments till repatriation, there is little hope for change in the trends. For more details on this issue refer to sections 3 and 5 of the Erie Lead article "Myth and Reality: Why Corporations Are Not Hiring" (click here: refer5).

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