this economy will need an additional jolt of $500 billion or so of government spending real quick. It must replace both reduced residential investment and consumption whose decline has placed the U.S. economy near, if not in a recession. Some quick math for you Sir: gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old C + I + G formula (scratch the trade deficit for now) when C + I is reduced by $500 billion, then G should increase by that amount in order to fill the gap. The G, Sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well there you have it: $500 billion + $500 billion = $1 trillion big ones, probably by sometime in 2011 or so. It takes time to spend those types of bucks. ... strong global growth spearheaded by developing countries and accompanied by significant commodity inflation should provide a firm background for stimulative U.S. monetary and fiscal policies during your first administration. Importantly as well, current negative real interest rates along with the innovative liquidity provisions by Bernanke’s Fed should promote “re” as opposed to “de“-flation. A trillion dollars of government deficit spending is potent medicine. Its potency regarding inflation will not be felt fully during the peak deficit period. Rather, inflation will accelerate during the subsequent recovery as the government bonds acquired during the recession are transformed once again into risk bearing assets and high levels of investment. That suggests that intermediate and long-term yields on government bonds have already bottomed and will gradually rise throughout your first, and perhaps second Administration. Your term will not go down in history as investor friendly.

Granted, you’re going to raise tax rates on the rich, give a break to the lower/middle class and rebalance the scales of economic justice somewhat. I myself won’t enjoy paying that near 50 percent marginal tax rate after you remove the current cap on the payroll tax, but my wealthy neighbors and I in Newport Beach should just look at it this way: we’ve had an eight-year lease extension on the “high life.” Now it’s time to give something back and I suspect we won’t be working any less hard.

"Men cannot escape being governed. Either they must govern themselves or they must submit to being governed by others."
- Theodore Roosevelt

Excellent point, Galenrox.

Mr. Gross' piece is, in substance, a repeat of his September 2007 commentary in which he called for a massive government bailout of the housing sector of a magnitude that would rival Franklin Roosevelt's New Deal Era policies.

In that earlier piece, he wrote:

The ultimate solution, it seems to me, must not emanate from the bowels of Fed headquarters on Constitution Avenue, but from the West Wing of 1600 Pennsylvania Avenue. Fiscal, not monetary policy should be the preferred remedy, one scaling Rooseveltian proportions emblematic of the RFC, or perhaps to be more current, the RTC in the early 1990s when the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner? The time has come to acknowledge that there are precedents aplenty in the long and even recent history of American policy making. This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hard working Americans whose recent hours have become ones of frantic desperation. And for those who would still have them eat some Wall Street cake as opposed to Midwest meat & potatoes (The Wall Street Journal editorial page suggested they should get darn good and used to renting once again) look at it this way: your stocks and risk-oriented levered investments will spring to life like the wild flowers in Death Valley after a flash flood. And if you’re a Republican office holder, you’d win a new constituency of voters – “almost homeless homeowners” – for generations to come. Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?

At present, it appears that Mr. Gross' fundamental problem is that he appears fixated on the housing sector to the expense of the overall economy and is, thus, reading the present macroeconomic situation as a replay of the Great Depression, which was a deflationary event.

Mr. Gross is wrong for two reasons:

1) The ongoing economic downturn does not even begin to rival the Great Depression in terms of its magnitude.

2) The macroeconomic environment is not defined solely by a deflationary phenomenon. Instead, it consists of the smaller deflationary dissipation of the housing bubble that is occurring in the midst of a larger increasingly inflationary environment.

Given his errors, although the Great Depression-type remedy Mr. Gross prefers might address some of the housing-related matters (but create moral hazard in the process), it would present the risk of inflicting far larger macroeconomic damage by feeding demand at a time when inflation is on the rise. By fueling an increase in aggregate demand, the Gross prescription would serve as a booster rocket for the ongoing inflation. As a result, the present inflation issue could well challenge or surpass that which arose during the 1970s, especially if Gross' fiscal expansion triggers a disorderly decline in the U.S. dollar.

Iceland offers a microcosm of what can happen when a nation's currency falls into a disorderly decline. There, 12.7% inflation is roiling economic activity and the central bank has been forced to raise its benchmark interest rate to 15.5%.

In terms of the larger global economic situation, a disorderly decline in the U.S. dollar on foreign exchange markets would inflict widespread economic damage, as unlike the Icelandic króna, the American dollar is a world reserve currency. A disorderly decline in the value of the U.S.dollar would also supercharge an already high price of crude oil, considering that oil is denominated in dollars.

In the end, whomever is elected President in November would do very well to ignore Mr. Gross' grand project to recreate a "New Deal" for the 2000s. A trillion dollar annual deficit would greatly damage the U.S. economy, inflict harm on the global economy, and substantially aggravate the nation's long-range fiscal imbalances.

I doubt either candidate will embrace Gross thinking that "this economy will need an additional jolt of $500 billion or so of government spending real quick." Neither candidate would risk such a reckless start to his Administration. Hence, at least through their first term, I do not believe either Senator Obama or Senator McCain would run up a $1 trillion annual budget deficit.

More information on the implosion of the Japanese asset bubbles, as I believe it is important to take a rigorous look at some of the key assumptions underpinning Mr. Gross' call for policies that would lead to a $1 trillion annual budget deficit.

Here's what Charles P. Kindleberger and Robert Aliber wrote of those bubbles in their seminal Manias, Panics, and Crashes, which is among the leading works on asset bubbles:

When the bubbles in Japanese real estate and stocks imploded, the losses incurred by the Japanese banks were many times their capital and virtually all the Japanese banks became wards of their governments...

The losses incurred by the banks headquartered in Tokyo and Osaka—eventually a burden on the country’s taxpayers—were more than 25 percent of Japan’s GDP.

...housing prices had soared to such a height that only those who qualified for one-hundred-year or three-generation mortgages could afford to buy.

At its peak, the value of real estate in Japan was twice the value of real estate in the United States; the ratio of the value of real estate to GDP in Japan was four times that in the United States.

The Nikkei stock market index, which started at 100 in May 1949, had reached 6,000 by the early 1980s. Stock prices surged in the second half of the 1980s and nearly reached 40,000 at the end of 1989…

Source:Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes (Fifth Edition), Hoboken, New Jersey: John Wiley & Sons, Inc., 2005.

Furthermore, with respect to a highly stimulative monetary policy having contributed to the buildup of the housing bubble that is now in the process of dissipating, Bank of International Settlements General Manager Malcolm D. Knight explained earlier today, "...low real yields at the long end of the maturity spectrum had, in the years before the recent turmoil, tempted some market participants to take on too many risks and to price them too generously." In short, very low long-term interest rates, including mortgage rates, paved the way for the asset bubble that is now contracting.

Finally, with respect to the strongly held opinion among many forecasters that the current bout of inflation will recede in the near-term, he warned, "But we cannot be entirely confident about this reassuring assessment. Forecasters did not expect the successive increases in commodity prices and so underpredicted the present level of headline inflation. And inflation expectations, particularly those indicated by consumer surveys, have edged up significantly higher in recent months."

In sum, the Japanese asset bubbles were of a magnitude far greater than those in the U.S. That reality requires a strong dose of caution when referencing the Japanese fiscal deficit as a percentage of GDP in the post-bubble years. In addition, BIS General Manager Malcolm Knight's observations concerning the role low long-term yields played in helping fuel the U.S. housing bubble and the errors to date of the consensus expecting inflation to disappear fairly quickly raise legitimate reasons to question the validity of Mr. Gross' continuing call "for stimulative U.S. monetary and fiscal policies" during the first term of whomever is elected President of the U.S. in November.

For those who are interested, Senator Obama's campaign has rejected Mr. Gross's suggested $1 trillion deficit. In an interview conducted by CNBC host Larry Kudlow, Senator Obama's economic policy director Jason Furman dismissed Mr. Gross's suggestion.

The relevant excerpts follow:

Kudlow: What do you think about this bond guy – this is so fascinating Jason, I want to let you take a whack at this – famous bond guy Bill Gross of Pimco out in the West Coast. He’s posted this letter to Senator Obama, and basically he says we need a trillion dollar, a trillion dollar deficit, in order to stimulate the American economy. You’re an old hand on fiscal policy. What’s your response to Bill Gross’s recommendation to Senator Obama?

Furman: Well Larry, you know Senator Obama likes to listen to a wide range of voices and a lot of different ideas. [But] I think a trillion dollar deficit is a little bit outside of the range of advice we’re interested in getting. We want to cut the deficit from where it is this year, and that’s one of the important changes that should reassure people about our economic policy.