Stan makes an excellent point this morning.  The bond market is very aware of the rapid deterioration of deficit forecasts and is poised to raise interest rates with or without the Fed as reported by Matt Benjamin of Bloomberg today.  Unless the economy worsens considerably, higher interest rates are likely by inauguration day.  I fear that the next president and Congress may ignore the markets and enact expensive new tax and spending programs anyway.  We've been through this fight before in the 1980s.

Back then, Wall Street economist, Ed Yardeni, coined the term "bond vigilantes" back when Ronald Reagan ran the highest peacetime deficits in history.  Yardeni's prediction of higher interest rates made him very well known among investors.  On May 29th, Ed issued a similar prediction.

Take a look at his chart of real interest rates from the San Franciso Fed and this chart of real GDP growth during the 1980s from the President's Council of Economic Advisers.  They show what happened when federal deficits ran out of control in the 1980s.  High real interest rates choked off recovery from the 1980 recession until early 1983, and real growth turned down again in 1986, but stopped short of a recession.  The first chart also shows the "neutral real rate" required to keep the economy at full production.  With the credit crisis, it has moved negative, where it remains today.  It will take us at least another year or two to come out of our economic "slowdown," and rising interest rates could easily choke that recovery off.

Hopefully, the next president will take a good look at President Clinton's first year in office, 1993.  Robert Rubin convinced him to enact a strong deficit reduction program.  It built upon the even stronger deficit reduction of 1990 by President Bush 41, which cost him his second term.  In 1994, President Clinton lost control of Congress.  These courageous, but politically costly, actions by presidents of both parties made the 1990s the best decade for economic growth since the Second World War, and they also produced budget surpluses in Fiscal Years 1998 through 2001.

New presidents rarely elevate fiscal discipline above their promises to the voters, but when they do, we're all better off.