March 24 (Bloomberg) -- The U.S. may pay a steep price to free itself of its economic and financial travails: bigger government, faster inflation and a poorer country.

That would mark a reversal from the course of much of the past two decades, when Washington has been dismantling regulations, the Federal Reserve has been largely successful in containing inflation, and many Americans have felt wealthier thanks to rising home prices and cheaper imports.

``We're going to have 4 to 5 percent inflation,'' says Kenneth Rogoff, former chief economist for the International Monetary Fund who's now at Harvard University. ``The dollar will continue to drop and stay down for years. And we're going to end up with more regulation.''

The seeds of that outcome are already being planted. Fed Chairman Ben S. Bernanke and his colleagues acknowledged last week that inflation expectations may have risen, even as they cut the benchmark interest rate three-quarters of a percentage point and began lending directly to big Wall Street dealers. Lawmakers are discussing expanding the government's role in the housing market and increasing oversight of financial services.

Americans sense that the economy is changing for the worse. Some 45 percent of consumers expect their inflation-adjusted incomes to fall in the coming year, the worst outlook since 1990, according to a University of Michigan/Reuters survey.

More Pessimists

``The pessimists are beginning to outnumber the optimists,'' says Lynn Franco, who runs a separate monthly survey of consumers for the New York-based Conference Board. ``Expectations about the future are at a 17-year low.''

What's happening, economists say, is the bill is coming due for Americans after years of living beyond their means. Over the last 15 years, domestic demand has grown an average 0.3 percentage point more per year than the overall economy.

``We've been spending more than the economy's been producing,'' former Fed Chairman Paul Volcker said March 18 on the Charlie Rose television show. ``So we have been depending increasingly on foreign finance -- monies coming from abroad.''

Behind the borrowing binge were rising asset prices, first for stocks in the late 1990s, then for real estate. Those bubbles have now burst, with house prices in 20 metropolitan areas down a record 9.1 percent in December from a year earlier, according to the Case-Shiller index.

Unpleasant Discovery

``It's like a person who discovers that he's not going to inherit something that he was counting on inheriting,'' says Nobel laureate Edmund Phelps, an economics professor at Columbia University. ``Suddenly he works harder, he saves more, he accepts worse terms for various things.''

Edwin Truman, a former Fed official now at the Peterson Institute for International Economics in Washington, sees a return of the ``malaise'' of the early 1990s. That was a period when domestic demand grew more slowly than the economy, with exports making up the difference.

Helping to drive that adjustment: the falling dollar. Since the Fed started cutting interest rates in September, the dollar has dropped 10 percent against the euro and 15 percent versus the yen. Allen Sinai, chief economist at Decision Economics in New York, forecasts a further fall, with the euro rising to $1.70 to $1.75 and the yen strengthening to 90 per dollar in coming months. The euro traded at $1.53 at 2:58 p.m. in Tokyo, while the dollar was at 99.82 yen.

Import Costs

The depreciating dollar threatens to push up inflation by raising the cost of imports. Import prices excluding petroleum rose at a year-over-year rate of 4.5 percent in February, the fastest rise in more than a dozen years.

``Inflationary pressures are coming at us from a lot of different directions,'' Rogoff says.

David Dillon, chief executive officer of Cincinnati-based Kroger Co., agrees. ``We don't think it's abating at this point,'' the head of the country's biggest grocery chain said on a March 11 conference call.

Rogoff says the Fed has set aside concern about inflation to concentrate on fighting the recession and the turmoil in financial markets.

`They're caught up in the immediate crisis and are flooding the system with money,'' he says. ``Inflation expectations are going to become unglued.''

Seeds of Inflation

Phelps says that might be one unintended consequence of the Fed's efforts to combat the crisis. These may end up holding the unemployment rate below its long-run natural rate of more than 5 percent, potentially leading to faster inflation, he says. February unemployment was 4.8 percent.

Increased government involvement in the economy also seems to be in store. The Fed is already providing $30 billion to JPMorgan Chase & Co. to help finance the purchase of Bear Stearns Cos. after a run on Wall Street's fifth-largest securities firm.

Treasury Secretary Henry Paulson has brokered agreements among lenders to freeze interest rates on subprime loans and to help struggling borrowers renegotiate loans. Democratic lawmakers, including House Financial Services Committee Chairman Barney Frank of Massachusetts and Senate Banking Committee Chairman Chris Dodd of Connecticut, are pressing for the government to do more.

Former Treasury Secretary Robert Rubin says all options should be on the table. ``I would be very, very seriously considering the possibility of using public funds in one form or another,'' Rubin, now chairman of the executive committee at Citigroup Inc. in New York, said in a March 21 interview with Bloomberg Television.

Battle Lines

Republicans and Democrats are also drawing battle lines over what should be done to prevent future crises. Paulson, while saying that regulators need to step up scrutiny of the markets, cautions against going too far.

The Democrats who control Congress are more worried about doing too little. ``We now see a situation in which more damage was done by inadequate regulation than by excessive regulation,'' Frank told the Greater Boston Chamber of Commerce on March 20.

``We've got a bad bargain,'' adds Raghuram Rajan, a former IMF chief economist who's now at the University of Chicago. ``The Street gets all the upside and the government gets the downside'' when Washington has to rescue firms in times of trouble.

In the wake of the bursting of the stock market bubble in 2000 and the collapse of Enron Corp., Congress passed the Sarbanes-Oxley Act (SOX). It required corporate managers to attest to the accuracy of their financial statements, toughened accounting rules and increased the authority of the Securities and Exchange Commission to police fraud.

Now, says Rogoff, ``We're going to end up with SOX squared.''

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net.

Last Updated: March 24, 2008 02:02 EDT