If: the economy continues to slow down and the government does not pass new stimulus programs, will the U.S. head into a deflationary spiral?

Recent economic data and Chairman Bernanke’s recent statement suggest the economy is slowing down. The “’09 stimulus package” has peaked and its effects will be gone by the end of the year. The G20 agreement reached over the weekend says governments “agree” to cut their deficits by 50% within two years. The U.S. would have to cut almost $800 billion of the $1.5 trillion deficit in 2010 alone. Good luck with that. Here are some reactions:

Keynesian (Demand-Side) economists are up in arms. Paul Krugman in an article in the New York Times today has an article titled, “The Third Depression.” He states that we are worried about inflation when the real problem is deflation; and the failure to stimulate (re-inflate) the economy will result in a long, Japanese style deflationary environment. He has suggested another $one trillion in stimulus.

The Keynesian-lite (Supply-Side) economists are still convinced the economy is turning around (although they have become less passionate in the past week) and that inflation is the potential risk. They do want taxes reduced to create jobs (but without cutting spending, you simply have a different type of stimulus program.)

The Capitalist economists see de-leveraging or deflation which is normal after our world-wide, gigantic credit bubble fighting inflation (low interest rates and the massive printing of money.) If this deflation-inflation struggle continues, it will take a long time to get to price equilibrium (e.g., bottom on home prices) and the amount of money created by that time will cause huge inflation. Therefore, the sooner the government gets out of the way, the sooner the recovery can begin.

Since we have a mixed economy rather than a capitalist economy, I do not expect the government to get out of the way. And since we have Keynesian government and Federal Reserve, I expect more stimulus rather than austerity.

However, many taxpayers are upset with all the spending. I had expected another large stimulus package this year, but one large stimulus package does not seem viable in this climate. Then, I expected to see the large stimulus package broken down into smaller pieces (a $50 billion package for unemployment benefits, a $50 billion package to help the states, an $8 billion package to hold up home prices, etc.). But last week, the Senate was unable to get closure on the unemployment package and therefore could not vote on it.. This might signal that additional stimulus through fiscal policy, may be difficult to do.

However, I think the answer to question posed is no. The government is to frightened of deflation to let it happen. Therefore, the Fed and Chairman Bernanke may be called upon to stimulate the economy through monetary policy (keep interest rates low and print, print, print money.)