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US economy: Where is the money?

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Are you trying to decide whether the U.S. economy's relatively weak performance in the first quarter of this year is just a proverbial "pause that refreshes," or whether it's a continuation of a trend of lackluster growth for the foreseeable future?

Here is what I think.

To sort this argument out, one has to look at two closely intertwined sets of factors. In an actual economic system these factors are inseparable and in a state of constant interaction, but I shall separate them here for the sake of clarity.

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The first set consists of variables directly underpinning an economy's growth dynamics. The space of the second set is occupied by demand management policies.

Employment, household incomes and net exports are the key components of the first set. And the story they are telling us about the U.S. economy is not good.

Weak demand drivers

The officially reported unemployment rate of 6.3 percent in April vastly underestimates the true slack in U.S. labor markets. If one adds to the 9.8 million people on official unemployment rolls 7.5 million of involuntary part-time workers (people working part-time because they can't find a stable full-time employment) and 2.2 million people who dropped out of the labor force because they could not find a job, the actual unemployment rate is close to 13 percent.

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More worrying perhaps is the fact that the labor participation rate (the percentage of population in the civilian labor force) of 62.8 percent is at the level seen during the stagflation period in the late 1970s.

Household incomes are faring no better. Over the last four quarters, the real after-tax personal income has grown at an average annual rate of only 1.2 percent.

Now, these employment and income data are directly underpinning household consumption and residential investment, which account for 75 percent of the U.S. economy. Is it any wonder, then, that over the last four quarters consumer spending rose only at an average annual rate of 2.2 percent, while the housing sector growth collapsed from a 15.1 percent increase in the second quarter of last year to 2.5 percent in the first quarter of this year?

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And the damage does not stop there because these three-quarters of the U.S. economy are also influencing business investments on plant and equipment. The growth in that key segment of domestic demand was nearly halved over the last four quarters to an annual gain of 3.1 percent from 5.8 percent in the previous four quarters.

Can the U.S. economy get some help from external demand?

Early signs so far this year hold some promise. The U.S. trade deficit in the first quarter was roughly unchanged from the year earlier and was running at an annualized rate of $632 billion, a 10 percent decline from the deficit for 2013 as a whole. The EU was the main drag on America's growth in the first quarter; its trade surplus with the U.S. increased by nearly 9 percent from the year earlier. Germany accounted for one half of American trade deficit with the EU.

The best one can expect here is that the U.S. trade deficit could take a somewhat smaller slice of domestic demand than was the case last year. But the U.S. cannot count on an export stimulus from the sluggish EU economy, China's stabilizing growth at around 7.5 percent and Japan's apparent reliance on a weaker yen and stronger exports.

The Fed should stop printing and chase the money out

This brings us to the second set of factors in the form of demand management policies.

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The U.S. fiscal policy is a politically charged issue in the best of times. It is especially so in the run-up to Congressional elections next November, and at the time when declared and undeclared candidates for the presidential race in 2016 are already staking their positions. So, let's stay away from politics and stick closer to economics.

The mainstream economic teaching, overwhelming empirical evidence and plain common sense tell us that a cyclical weakness in private sector demand should be offset by tax cuts and/or stronger government spending to keep the economy growing. None of that is Washington's realistic policy option at the moment. With the government spending falling at an average annual rate of 2.2 percent over the last four quarters, and the budget deficit expected to decline this fiscal year to 2.8 percent of the gross domestic product (GDP), the U.S. fiscal policy is quite restrictive at the time when it should at least be neutral.

By contrast, the monetary policy is wildly expansionary, but its transmission mechanism is largely out of order.

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What else can be said when the U.S. commercial bank lending to the households was falling in the first quarter at an annualized rate of 8.8 percent? And when these same banks were holding, on May 28, 2014, at the U.S. Federal Reserve (Fed) $2.6 trillion of excess reserves (i.e., loanable funds) at an interest rate of 0.25 percent instead of lending them out to creditworthy households at interest rates of 10 percent or more.

In case you suspect that there are no creditworthy households, or that their loan demand is too weak, please note that nonbank (finance companies, credit unions, etc.) lending to consumers rose in the first quarter at an annualized rate of 6 percent.

The message for the Fed is clear: Stop printing more money, but do chase the idle money out of your books.

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As an aside for those of you looking over the pond: The same message is fully valid for the European Central Bank (ECB), which apparently contemplates an easing move while its banks' lending to the private sector has been falling at an annual rate of 2.1 percent in the first four months of this year -- in spite of an amply available euro liquidity at 0.25 percent.

Investment thoughts

I have no advice for the Fed to unlock banks' consumer lending. I am sure the Fed can figure that out without any outside help. But until the Fed does something about that, it is unlikely that the U.S. economy will get the fuel it needs to defy the pessimistic metaphors of an airplane forever taxiing in search of an active runway.

I believe that the problem of banks' liquidity hoarding should be addressed with a great sense of urgency. That would be much more useful than the sterile talk about "market guidance" and future rate hikes in an economy strangled by tight fiscal policy and clogged channels of financial intermediation.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9