The U.S. economy is out of the frying pan and into the fire, Warren Buffett writes in an op-ed piece in the New York Times today. The very actions that saved the financial system from the brink of ruin now threaten the long-term health of the dollar.

"The United States economy is now out of the emergency room and appears to be on a slow path to recovery," Buffett wrote. But rescuing banks and the unregulated "shadow banking system" comes at a high cost, and will result in a budget deficit of $1.8 trillion this year, or 13 percent of gross domestic product. Excluding World War II, this is more than twice as high as anytime since 1920.

Even with the assumption that Americans will save $500 billion this year and use it exclusively to purchase Treasuries, the funding gap between what the government will spend and what it will collect from tax revenues and borrowing will still be $900 billion. Rates on Treasuries must rise to attract more investment capital, or the Federal Reserve will have to print money (or the electronic equivalent) to fill the void. Regardless of the course, each path comes with its own set of consequences.

Of course, higher inflation is the necessary outcome of any move by the Fed to run its printing presses faster. This is particularly troublesome because it is an easier option than bringing spending in line with tax revenues. As Buffett says, "Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes." This politically convenient option may seem to work for a time, but eventually results in a "banana republic" as lenders realize what is happening.

Fiscal prudence -- on both a personal and governmental level -- is what's needed to solve this crisis before it flares up. But Buffett cautions that "will require extraordinary political will," to which I would add voters willing to hold politicians accountable for spending public tax dollars. Given the less-than-ideal world we live in, I worry that Buffett is wearing the same rose-colored glasses as Federal Reserve Chairman Ben Bernanke, and is trying to have his cake and eat it too.

While Buffett is clearly in the camp that favors huge amounts of fiscal stimulus, he desires that the Fed end its current easy money policies and Congress pull back on its mandate to send out or spend hundreds of billions of dollars when the time is right. Much faith is being placed in the Fed to make the correct call on tightening, or an "exit strategy," when they have failed to do so time and time again in the past.

James Cullen edits and writes at CollegeAnalysts.com.


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