It now appears that the net result of the debt ceiling/fiscal cliff drama has been a tax increase for upper income Americans. This does not bode well for Republican efforts to cut federal spending by emphasizing the debt/deficit set of issues. It also leaves the Republicans with a nasty dilemma - exactly what alternative vision of America's future do they want to be identified with? More immediately, do they really want to convince the country that the debt/deficit issue is so important that it justifies further tax increases?
The Republican Party has inherited the old William Jennings Bryan coalition of Southern, Great Plains and Northern Rocky Mountain states; the 2004 election map is almost a carbon copy of its 1916 counterpart except for the fact that the Republicans in 2004 carried almost exactly the same states carried by the Democrats in 1916. Although Karl Rove admired William McKinley, he actually delivered the Republican Party into the hands of the same kinds of voters who voted for Bryan against McKinley in 1896 - rural Americans and religious fundamentalists. Bryan recognized that his rural coalition - largely dependent upon the agriculture and mining and the production of commodities - would benefit from "easy money" and so attacked the gold standard ("You shall not crucify mankind upon a cross of gold!") and advocated the free coinage of silver.
The Southern and Western states became reliably Democrat and benefited from New Deal efforts to revive the economy. Programs targeted at these states - Henry Wallace's generous farm subsidies, massive hydroelectric projects, subsidies for rural electrification, the TVA, land reclamation projects, and finally loads of military bases helped keep these states in the Democrat column until the combined forces of the Civil Rights revolution, cultural conflicts, and amnesia concerning the Depression led them into the Republican column. In many of these states, much of the land is owned by the federal government and the economy still depends heavily upon the terms and conditions the feds apply for grazing permits, mining and logging rights, etc. The New Deal did a lot for these states: it was good for the people who lived there and it was good for the country as a whole.
The Republicans are not only the party of the Bryan states but also the party out of power. The party out of power always has made the national debt and the current deficit a big issue - Ross Perot used this issue to help Bill Clinton get elected in 1992 and it has been with us ever since. The Republicans have periodically terrorized the Obama Administration with threats to refuse to increase the debt ceiling or to allow the country to fall over the "fiscal cliff." They solemnly express concern over the national debt - often in terms which ignore the fact that it is very different from private debt because it is owed in a currency which we can print. Americans probably think that someday the Chinese will repo a U.S. aircraft carrier or that the mysterious Federal Reserve will foreclose on the White House because of the Treasury's inability to meet its payments. Explaining that this is not a problem because of our unlimited ability to create more money actually creates another, more basic, terror - that we could go the way of the Weimar Republic with hyperinflation. A few Republicans have seized upon this issue and advocated a return to the gold standard- or at least the pursuit of a "stronger" dollar.
For politicians, the deficit is a great attack issue as long as one is not put in the position of actually suggesting a solution. Our sluggish economy suggests the need for deficit spending, but this could be in the form of tax reductions or spending increases. Lots of Americans are aware that the federal government wastes a lot of money and there is probably a consensus in favor of shrinking and better focusing the government of its core priorities. But when the issue is framed in the form of deficit reduction, it comes into conflict with the goal of economic revival and also implies a solution in the form of increased taxes.
Federal spending could be cut but many of the most attractive targets - reduced farm subsidies, closing military bases, higher user charges for mining, logging, and grazing on federal land - would be very, very unpopular in the "Red" states. Social Security and Medicare could be "needs tested" but that would be equivalent to a tax on older, more affluent Americans - another Republican constituency. We could always pay less to doctors and drug companies - but yet another group of reliably Republican voters would be adversely affected.
It would be more honest for the Republicans to make wasteful federal spending the issue. If there is wasteful federal spending - and there certainly is - it should be cut whether or not we have a deficit. If the economy needs fiscal stimulus, it need not be in the form of spending; it could take the form of tax cuts or rebates or revenue sharing with the states. The wasteful spending issue should be separated from the deficit issue because they really involve very different considerations. The desirability of a deficit depends upon where we are in the business cycle; the desirability of spending depends upon a cost/benefit analysis of the impact of the spending. But the deficit is just too easy a target for the party out of power to pass up and so it will continue to be the focus of policy debate. There will not be meaningful reductions in federal spending; wasteful spending is there for a reason and the reason is almost always political. To add to the confusion, a focus on the deficit invites the tit-for-tat trading of tax increases for spending cuts and an endless circle of finger pointing between the two parties.
As a result of this policy dysfunction, we are not on the verge of a "grand bargain" or a stable solution to the federal spending issue. Deficits will continue because there is really no acceptable alternative, but there will be constant squalls concerning the debt ceiling, the budget, and other battlegrounds which will demonstrate a scary lack of both consensus and predictability. There will be constant anxiety about the possibility of spending cutbacks and tax increases that will never actually occur. As I have written here, Ricardian Equivalence tells us that this will lead businesses and households to be frugal and so the economy will stumble along.
With inadequate fiscal stimulus and stunted consumer and business spending due to policy uncertainty, constant pressure will be put on monetary policy to avoid the danger of a deflationary depression. While some Republicans threatened to fire Bernanke (a Republican appointee) and have espoused a "strong dollar" policy from time to time, nothing could be more disastrous for the Red states than an increase in the trade weighted value of the dollar. Commodity prices would decline, BMW (OTCPK:BAMXF) would make cars in Regensburg rather than Spartanburg and the energy industry would take a tumble. William Jennings Bryan got this one right; the rural states do a lot better with a weak dollar. And another important Republican constituency - big business - is not crazy about a stronger dollar either. A stronger dollar makes it harder for CEOs to report higher earnings each quarter because earnings are denominated in dollars. So the battles over monetary policy will be largely rhetorical, with business leaders telling Republicans to "back off" as soon as they blunder into specific legislation curbing the Fed.
Here's what is almost inevitably going to unfold over the next 5 years. Interest rates will stay low except for a brief effort to raise rates in 2015; the short rate may get to 1% and the 10 year to 3.5% but any sign of an adverse reaction will cause the Fed to halt, and even reverse, tentative rate increases. The Fed will not want to raise rates immediately before the 2016 election and so it is hard to see them getting over 1% until well into 2017. With the Japanese and virtually every other country trying to improve their trade positions by weakening their currencies, the United States will mud wrestle every other country in the World to try to be sure its currency is not "overvalued." This will be yet another brake on efforts to raise short term rates.
With this future prospect in mind, dividend stocks are an incredible bargain here. Investors should be backing up the truck to buy dividend stocks, BDCs and REITs, and other investments yielding more than bonds. Bond prices will probably not decline much but it is very hard to see them going higher either. A dividend stock led bull market could appreciate considerably from here. Squalls will provide buying opportunities but dips may be shallow because there will be lots of investors waiting to capitalize on them. Have fun but be careful out there!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.