Will the disaster in Japan lead to a double dip recession?

Here is a possible scenario I have been thinking about.

It appears likely that the disaster in Japan will cause shortages of a lot of components needed for manufacturing various products, and this will quickly lead to reduced output of a lot of products in plants all over the world because most manufacturing operations use "just in time" inventory management and therefore don't keep a big supply on hand of the components they need to make their products.

The reduced supply of a number of products will then cause a rise in the prices of those products under the laws of supply and demand.

The rising prices of a number of products, especially when coupled with rising energy prices due to the disruption in the Middle East, will lead many people to conclude that inflation is picking up.   This will lead to increased pressure on the Fed to tighten.

If the Fed does indeed tighten monetary policy in the face of these supply-shock rising prices it could trigger a second recession.

The key point is that rising prices due to supply shocks are *not* an indication of an overheating economy that needs to be reined in using monetary policy.  They are just an indication of real shortages of real goods.

Trying to fight price increases caused by real shortages by tightening monetary policy is not a smart choice.  If the Fed lets shortage induced price increases run their natural course the rising prices will reduce demand for the particular goods in short supply until equilibrium is reached, and other industries will not be directly affected.  If the Fed tries to fight shortage induced price increases by tightening monetary policy the demand for all goods, even those not in short supply, will be reduced, and all industries will see a reduction in demand, i.e. a recession.


Discouraged by the focus on deficit cutting

The recent enthusiasm for reducing the deficit has me extremely discouraged.

Job creation is at a pace where we will be back at full employment (say in the 5% unemployment range) in . . . well, never.  We still haven't seen job creation that will significantly reduce unemployment in a reasonable number of years.  A drop in consumer spending caused this recession, so a rise in consumer spending will be required to fix it, but consumer spending, while it has been growing, has not been growing at a pace that would bring down unemployment at a reasonable pace.  There is no particular reason to think that the rate of increase in consumer spending will accelerate any time soon.  Housing prices are continuing to fall, and households are still carrying a lot of debt, so it's hard to see a reason for consumers to start spending substantially more of each paycheck.  In short, there is no reason to expect strong economic growth for the next few years.

In this context, any reduction in government spending, or even any reduction in the rate of growth of government spending, will slow economic growth at a time when we can't afford to be slowing economic growth.  Every $40,000 or so reduction in government spending will be around one more unemployed person.  Since the population is steadily growing, even holding government spending stable will tend to help keep unemployment high. So when politicians of both parties talk about reducing government spending and the deficit, what I hear is politicians advocating for increasing unemployment.

Of course the Conservatives argue that reduced government spending will somehow stimulate private job creation, but I just don't see how.  The only plausible mechanism by which government deficit spending holds back private job creation is by driving up interest rates which in turn reduces real investment.  However, interest rates are at near record lows, so its hard to see how additional reductions in the interest rate would spark much more investment.

In any event, here is what the next few years look like to me at this point.   Congress slows the growth of government spending, or even reduces it, over the next year.  As a result unemployment falls only a percent or two over the next two years at best, and at worst it stays above 9% or even breaks into double digits.  Economic stagnation going into the 2012 election results in Republicans taking the Presidency and possibly the Senate and increasing their numbers in the house.   Then after 2012 government spending is cut at an increasing rate with the government under solid Republican control, resulting in high unemployment continuing and maybe getting worse.

What will 3-10 years of unemployment above 7% mean for America?