We are coming to a critical inflection point, perhaps the most critical point that we have had in 70 years for the US and to a great extent the global economy. The choices we make (or that Congress and the Fed make for us) will affect not just our investment portfolios but business and our jobs for a very long time.  You need to clearly understand what the risks are so that you can interpret the actions and data that will be coming at us in the next few quarters.

Outlined here are three possible paths for the economy based upon the political
choices we make about the budget deficits.
First, there is the benign path, where we more or less roll back the Bush tax cuts,
and do not increase spending for new programs. The fiscal deficit falls into a
manageable range. We repeat the Clinton years where spending is help below
increase in revenue so that over time the budget gets balanced. While a large
tax increase would have negative consequences for the overall economy, it is
far better than the other two paths strictly from the perspective of growing
the economy as much as possible. This path also has a very small probability.

The second path is that the Obama budget is passed, the Bush tax cuts go away and we have a decade of projected trillion dollar deficits. By the way, those
deficits assume 3% growth rates, low unemployment, low interest rates and very
large health care savings, and a withdrawal from Iraq and Afghanistan. The
deficits are likely to be MUCH larger than the CBO forecasts. This is on top of
exploding entitlement expenditures in the middle of the next decade, which are
underscored in the opinion of more conservative analysts.

The third path is the same as above expect that large new taxes are passed in order to bring the deficit to a manageable size relative to the growth of GDP. This
means that a tax increase over and above those projected by the Obama
administration of around $700 billion a year (about 5% of GDP!). Deficits would
still be in the $3-400 billion range, but from a funding perspective, it could
be done.

The second path is one that will end in heart ache. I do not think that the world
or even US investors can buy multiple trillions of dollars of debt for more
than a few years without rates rising significantly. That, as PIMCO’s Bill Gross points out, will affect both businesses and mortgage borrowers. It is a disastrous train-wreck.  The third path is the more likely.  There may be enough economically conservative Democratic that will realize the problems of trillion dollar deficits. But they do want a fully nationalized health care, and thus they will
pass enough in taxes to pay for it. If they are going to do it, this is their
one chance, as Republicans are likely to do better in the 2010 elections and get
enough votes to push back any real tax increases other than letting the Bush
tax cuts expire.

It will be difficult to ever go back. Perhaps new technologies and industries can
develop and help get us back on a path to higher growth later in the next
decade. We did survive the 70s, after all (Source: The Big Picture).