"The GOP's December Surprise"

Jamie Galbraith on political business cycles - the manipulation of the economy for political purposes causing cyclical regularities in the data - and the prospects for the economy after the election:

The GOP's December Surprise, by James K. Galbraith, Mother Jones: Is the worst over? Are we on the road to recovery? ... Early this year, the optimists ... argued that the slowdown was short-term and that a "stimulus" package should be "targeted and temporary." This with rare haste the Democratic Congress enacted. As a result, most taxpayers got one-time $600 checks in May...

The rebate isn't the only little Dutch boy thrown headlong at the dike this election year. Government spending, especially for defense, will be up... Dick Cheney was secretary of defense for Bush 41; just before the 1992 election he engineered a big run-up in outlays, as the military restocked following the first Gulf War. ... Is the Pentagon up to that trick again? I'd be astonished if it were not.

Under intense pressure from panicky bankers, Ben Bernanke cut interest rates relentlessly from August 2007 through the spring of 2008. I don't accuse Bernanke of playing politics. But it's worth noting that this is what usually happens. In presidential election years when Republicans are in office, the Fed ... pursues a more expansionary policy than when Democrats rule—after controlling for differences in the rates of inflation and unemployment. (I made these calculations myself; see the chart.) ...

But much of the ordinary effect of interest cuts on new lending—like a rebound in construction and automobile sales—didn't happen this time. ... Lower interest rates did cut the value of the dollar, however, and that promotes exports and foreign investment. ...

Possibly all this stimulus will ward off the two-quarter decline that has historically defined a recession. Don't be surprised: Republicans haven't had an election-year slump since 1960. .. Even if they can't stop a recession, they may be able to make it short and shallow enough, this year, to put John McCain in the White House. But all this brings up an important question—what of next year?

No matter how effective the stimulus, two enormous clouds remain for whoever becomes president: the housing slump and the banking crisis. Both are far from being finished yet.

The problem with a housing slump is inventory. Unlike factories and Internet startups, shuttered houses don't go away. ... They remain, a drag on the market, decaying and pulling down property values for years. ...

And ... homeowners are now getting hit a second way: in the declining value of their homes. You don't have to be holding a subprime to find yourself underwater. ...

Will students, small businesses, and other borrowers still be able to get credit when this is over? God only knows. The mechanisms of mortgage finance and home-equity drawdown haven't simply been damaged. That well has been poisoned. ...

Let's be clear. The private financial markets did actually fail. It's only the fact that the public trusts government that keeps the system from dissolving in panic. But even if the Fed and its counterparts can hold the line, the problem of mistrust among the big bankers won't go away soon. And that means we're at the end of the age of credit expansions, for now.

As for next year, good luck. No matter who becomes president, there probably won't be another tax cut. Instead, cries for "fiscal responsibility" will be heard. States and localities, hit in 2008 on their property taxes, will cut their spending. Consumers, hit hard on their home equity, will cut back on new borrowing (which they probably couldn't get anyway) and pinch pennies however they can. Businesses won't even think about new investments.

In this situation, more cuts to interest rates—the only applicable tool the Fed has—don't work well. And they weaken the dollar, which raises inflation. ...

Thus far the dollar has fallen, but it hasn't collapsed. Will it? There are two big threats. The first is the financial crisis itself... [T]he fundamental trust that ... the United States was a safe place to put your money ... has come into question.

The second threat, not often mentioned, is our reckless foreign policy, including the invasion of Iraq, bellicosity toward Iran, and the ongoing subtext of hostility toward China. Since the Middle East has the oil and China holds our debts, all this is spitting in the soup, big time. It may not by itself wreck the financial system. But it doesn't exactly build up the reserve of good will that we may need when the financial going gets tough.

For half a century much of the world believed that we provided security under which they too could prosper; many no longer think so. Today, our country, like our banks, has a problem of global trust. Unlike the banks, we have no higher power to keep things going if we screw up.