The Iowa caucuses appear to have done their usual job – dooming the Republican ticket in next November’s election. So I thought it worth looking at what another four years of President Obama might bring, and how deep might be the hole the U.S. will have to dig out of in 2017. “Be assured, my young friend, that there is a great deal of ruin in a nation” wrote Adam Smith in 1782, so on balance one can remain optimistic.

To diverge into political analysis for a moment, the Iowa Republican caucuses have a long history of promoting social conservatives with modest national appeal and questionable track records, while suppressing economic conservatives (the Democratic caucuses have an equivalently eccentric track record.) It’s not really surprising – Iowa is nearly 1,000 miles from the nearest international border and its economy is highly dependant on agricultural and ethanol subsidies, with not much of the free market about it. This time it promoted the social conservative and foreign policy neocon Rick Santorum, the libertarian pacifist Ron Paul and the moderate-liberal Mitt Romney, while suppressing more mainstream candidates with better track records, such as Texas Governor Rick Perry and to an extent former Speaker Newt Gingrich.

Assuming Perry and Gingrich don’t enjoy a miraculous revival in New Hampshire, South Carolina or Florida, it’s thus likely that the nominee will be Mitt Romney, easy for the Obama administration to attack on class warfare grounds, or, if Romney fails, Paul or Santorum, either of whom would be objectionable to a substantial element of the Republican coalition. Given Iowa’s efforts, therefore, the chance of a united and enthusiastic Republican campaign in 2012 is minimal, and Obama’s probability of re-election in November soared last Tuesday from around 50% to maybe 80%.

Given the assumption that Obama wins re-election, we can then map the economic policy trajectory of the following four years with some certainty. Obama would not have won re-election on a wave of new enthusiasm, or on the basis of a suddenly robust economic recovery, which appears unlikely before November, but simply because of the ineptitude and political vulnerability of his opposition. Hence he is unlikely to have significant coat-tails to pull Democratic Senators and Congressmen into office with him. Thus, with a large number of vulnerable Democrat Senate seats, the Republicans will probably gain the four seats necessary for bare control of the Senate, without losing control of the House.

The 2014 election, producing the Congress of Obama’s last two years, is more difficult to forecast at this time, but in the Senate the Democrats will be defending their outsize gains of 2008, so it’s likely the Republicans will pick up a further Senate seat or two, while possibly ceding back control of the House. In other words “gridlock” between Congress and the President is likely for the whole of Obama’s second term.

The result would not however be four years of stasis. Since a re-elected Obama’s political strength would be much greater in 2013 than it was in 2011, his ability to peel off a few Republicans to pass “consensus” legislation would be correspondingly greater. Moreover, much of his 2009-10 legislation, notably the healthcare law and the Dodd-Frank financial regulation law, has staged or delayed implementation provisions that might be blocked by a Republican President, but would be implemented in full by a re-elected Obama. The Obama healthcare legislation, which greatly increased state control over the healthcare sector, would thus enter on schedule in 2014 (in the unlikely event that the Supreme Court eliminates the individual mandate, the rest of the legislation will still stand, and the runaway cost of the legislation without the individual mandate would compel Congress to introduce something equivalent that would pass Supreme Court scrutiny.)

Since the cost of Obama’s healthcare bill was only balanced by accounting tricks (such as assuming large cuts in Medicaid) that will not pan out in practice, the Federal budget would thus after 2014 incur a major additional burden, potentially pushing deficits even beyond the frightening levels assumed by present legislation. Since the cost-cutting attempts of the newly elected Republican majority in 2011 ended with 2012 Federal spending higher than in 2011, we can assume that even the most determined attempt by Republicans in Congress to cut spending won’t work while Obama is President (and would probably be short-lived and only marginally effective even with a Republican President.)

Unless the economy is exceptionally strong, which is very unlikely – we’ll do that last! – the pressure for a major tax increase will thus become irresistible. Even if the budget deficit could be kept to crisis-avoiding levels through rigid spending control, Obama would reject that approach, because it would prevent him from introducing new spending programs, apparently his favorite political activity. Hence there will probably be three major tax increases. One will restore most of the pre-2001 tax levels, which will be impossible to stop should Obama win in November, if only because they are due to be restored automatically in January, giving a re-elected Obama a very strong negotiating position. A second tax increase will eliminate most of the current tax deductions for high earners, in particular the mortgage, charitable and state and local income tax deductions. Provided the charitable tax deduction was included, I would be in favor of this elimination, as would many Republicans, so it seems likely that in 2013 a bipartisan coalition will agree to some such measure.

The third major tax increase, by far the most significant, will be the introduction of a value added tax. With united Republican opposition, that could probably be avoided, since it would require contentious legislation. However Romney, the likely Republican Presidential nominee, has refused to rule it out, so united Republican opposition is likely to be impossible, provided Obama plays his cards intelligently and offers a sop to “bipartisanship” such as a corporate tax cut and perhaps a deeply reluctant abandonment of further tax rate increases on the rich. (The rich would already be suffering tax increases from the Medicare tax surcharge to be introduced in 2013, the reversal of the 2001/2003 tax cuts and state tax increases imposed by governments mired in deficit by sluggish economic growth.)

The introduction of a VAT, perhaps at a low initial rate of say 5%, will solve Obama’s problems. It is likely to be unpopular, but if it is passed under a cover of bipartisanship Obama and the Democrats should avoid most of the electoral blowback. Most important, once a VAT is in place, Obama’s healthcare plan will be funded and further Obama spending schemes will be possible without inflating budget deficits. Outlays, currently 23.8% of GDP and projected (unrealistically) by the Congressional Budget Office to decline to a low of 22% of GDP by 2015 before increasing thereafter, will with a VAT be able to increase further, to perhaps 27% of GDP by the end of Obama’s second term. Revenues will trail outlays, but instead of 20% of GDP in 2015 (including repeal of the 2001/2003 tax cuts) will rise to perhaps 24% of GDP, leaving the deficit at 3% of GDP, or about $500 billion in today’s money. Of course, were a further spending-prone President elected in 2016, outlays would rise further, as entitlement spending spiraled upwards, but that problem could be solved, at least in the short term, by increasing the VAT rate towards European levels.

Implementation of this policy mix would result in the U.S. economic growth rate slowing significantly, with the “speed limit” being perhaps 2% instead of the 3% we were used to before 2008. Aggressive regulation by enthusiastic Obama appointees in the energy and financial sectors might knock another half point off growth, without pushing the economy into outright recession – regulation would be a further drag, not a “shock.” As in the more sclerotic economies of Europe, unemployment would remain high, perhaps around current levels or even rising a little as tax increases kicked in. However with the budget deficit reduced by the tax increases, there would be only a modest chance of a further financial crisis or government debt default. Indeed the VAT introduction, providing a further bottomless pit of government revenue, might well persuade the rating agencies to restore the U.S. credit rating to AAA.

Monetary policy would remain loose, so inflation would continue creeping upwards, but the lags involved in the transmission between money growth and inflation, the continuing price-suppressing effect of global outsourcing, and aggressive manipulation of the statistics by the Obama-controlled Bureau of Labor Statistics, might well prevent the reported inflation level exceeding 15-20% before November 2016. In any case, inflation at moderate levels would be very popular with much of the populace, who would see the housing market recover nicely and their real value of the mortgages decline, with Obama naturally taking credit for the recovery. Losers would be holders of U.S. Treasuries and non-defaulted mortgages, most of whom are foreigners anyway.

By 2016, the disadvantages of Obama’s policies would be clearly apparent. However as in Britain in 1979, a partial reversal of them, with consequent long-term economic improvement, would still be possible. That would however require the Republicans to nominate a Presidential candidate who was economically principled, electable and capable, a tall order indeed. For this to be achieved, the good citizens of Iowa would have to be prevented from knocking this paragon out of the running in favor of a grossly inferior alternative – from experience, perhaps the highest hurdle of all!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)