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Yellen Ponders Policy as Politicians Ponder Deal

12:00 AM, Oct 26, 2013 • By IRWIN M. STELZER
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“The thrill is gone,” famously warbled B.B. King among others. And so it is for watchers of the U.S. economic scene. The eighteenth partial government shutdown is over, World War II veterans can legally visit the monument to their bravery, hikers can trek through national parks, and the National Institute of Health can resume its cancer research—all impossible to do when the Obama administration prevented amelioration of the hurt inflicted by the shutdown in order to maximize voter anger at the Republican party.

Janet Yellen

Nor do we have the thrill of being witnesses to history-in-the-making—a government default and the accompanying international catastrophe of collapsing share prices, shuttered banks and who knows what else. No need every morning to check whether the world economy is functioning: it is. Indeed, the government’s revenues so far exceed its interest obligations that a default was never in the cards, the president’s warnings to the contrary notwithstanding.

Fear not—the excitement will return very soon. The deal that broke the deadlock requires Senate Democrats and House Republicans to reconcile the differences in their budgets. And to do so by January 15.  Fat chance. The president says he will only accept a deal that includes substantial new revenues—aka, taxes—something Republicans cannot deliver. Any Republican who votes to raise taxes had better have an alternative career lined up, as he will soon be back in the private sector after losing a primary fight to some Tea Party challenger.

Even if this fundamental difference could be papered over, other hurdles cannot. Republicans are demanding that the run-away costs of entitlements such as Social Security (pensions) and Medicare (health care) be reined in lest the deficit, which has been dropping, explode in a few years. The President, in his budget, offered the modest concession of a more accurate inflation index to be applied to Social Security, only to be told by his core-left supporters that they won’t go along with any reduction in the scale or scope of the entitlement state. Obama is unlikely to risk a fight with those supporters, especially since he himself has no real taste for any reduction in the size of the entitlement state. So a divided Republican party is negotiating with a divided Democratic party in the hope of bridging the yawning gap that separates those who believe in expanding the welfare state, and those who equally firmly believe that there lies the road to ruin.

Those foreigners who enjoyed watching our government make a fool of itself during the last shutdown—often the very same who bemoan America’s retreat from the role of keeper of world peace and economic stability—and would enjoy watching a further humiliation of a country that infuriates them by styling itself “exceptional” and the “indispensable nation,” are doomed to disappointment. There will be no shutdown. If the parties can’t agree how and at what level the government will be funded, the money will anyhow flow. But only at the lower level of expenditure dictated by what has come to be called the sequester, a statute requiring across-the-board cuts in the funding of the military and of many social programs. The security-conscious wing of the Republican party will moan the decline in our military preparedness, but most of the party will live with further cuts in the military in order to retain the sequester’s shrinkage of total spending and reductions in the cost of social programs. Spending at sequester levels has already produced the first two-year reductions in government spending since the Korean War, no small victory for Republicans, who badly need a win, but a real worry for those who believe spending cuts—fiscal tightening—will further weaken the feeble recovery.

The only question is whether the pain inflicted on Democrats’ favorite social programs will be sufficient to induce them to accept a spending deal that Republicans also find acceptable. In any event, government spending seems set to come down just as Janet Yellen takes the reins of the Federal Reserve System.

Yellen, a long-time advocate of loose monetary policy as a tool for stimulating job creation (“Ms. QE Infinity” to her critics), will be faced with this tighter fiscal policy and a still-weak labor market. That combination will prompt the new Fed chairman to delay any “taper,” jargon for a reduction in Fed bond purchases (QE3) until early 2014 according to most analysts; my guess is that the vessel will remain at full-speed-ahead well into 2015. Whether the flow of paper money will keep interest rates at zero, or create a fear of inflation that drives them up is anyone’s guess.

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