Green shoots, oncoming trains

My new column for National Journal discusses signs of improvement in the economy, and worries about two longer term issues: the need for substantial tax increases, as yet entirely unacknowledged by the tough-choice specialists in the White House, and the difficulty of unwinding the Fed's extraordinary recent interventions. Referring to speeches this week by Obama and Bernanke, in which both pointed to signs of improvement, I say:

It is interesting that when Obama and Bernanke began to look beyond the immediate difficulties, they stopped reading from the same script.

The president talked about the need for fiscal discipline once the economic recovery is secure. Alluding to the Sermon on the Mount, he said this was to be one of the pillars of the "house upon a rock" that he hopes to build. Bernanke, in contrast, addressed the need in due course to reverse the Fed's aggressive interventions in financial markets...

"For too long," Obama complained yet again, "too many in Washington put off hard decisions for some other time, some other day."

Tough choices will have to be made, he said. Yes, they will. When does he intend to start discussing them?

His 10-year budget leaves a permanent fiscal gap of 4 percent of national income a year -- even after years of strong economic expansion, which the administration optimistically assumes, and despite the fact that the budget provides for half or less of the full cost of health care reform, as the White House admits. Entitlement reform as traditionally envisaged cannot close that gap. Nor can tweaking taxes by restoring "a sense of fairness and balance to our tax code by shutting down corporate loopholes and ensuring that everyone pays what they owe," as Obama put it.

To crank out that exhausted cliche even as he invokes the need for new honesty, the president must be either severely deluded or far more cynical than most people suppose. Make no mistake: His budget arithmetic calls for higher taxes -- much higher. That 4 percent of national income, which deliberately understates the fiscal hole, is equivalent to approximately half of what the current federal income tax collects. The president knows it is going to take a lot more than doing a few extra audits and closing a few loopholes to solve that problem. One hopes he does, anyway. So far, while constantly invoking the need to face difficult choices, he refuses to frame the one that matters most: How much are people willing to pay for the new things he wants the government to do?

Restoring fiscal balance is a huge challenge for the future, one the Obama administration is not yet willing to face. The Fed will have to confront a different and less obvious test, but one of equally daunting dimensions.

Bernanke has undertaken an extraordinary range of interventions to support the economy. They extend far beyond the Fed's traditional monetary policy tools, and they blur, if not erase, the line separating monetary policy and fiscal policy. Partly to evade congressional scrutiny of Treasury's actions, partly to get the cost of supporting the banks and shadow banks off the government's balance sheet, the Fed has committed trillions of dollars to reviving the market for securitized loans and supporting particular institutions or lines of business...

The great danger -- one that the financial markets have not begun to grapple with -- is that the two issues will merge. Persistent and irreparable budget imbalance, plus a central bank as fiscal partner, is a formula for surging inflation. There is no sign of it yet: With demand so depressed, deflation is still the greater danger.

But it is not too soon to start thinking about the problem, and preparing people for the increases in taxes that will eventually be needed to avert it.

You can read the rest of it here.