Edmund Phelps, who is currently professor of political economy at New York's Columbia University, said the budget impasse debate was a "fascinating" distraction from the U.S.'s more serious problems of decreased competitiveness and innovation.
(Read more: US senators hint at possible fiscal deal on Tuesday)
"The larger picture is that the American economy has been pretty sick for some time — since the 1970s — and the symptoms of that are low employment and participation, as well as slow growth and probably low job satisfaction. Nobody is addressing what the government could do and should do to fix that problem," Phelps said.
He added that the government was propping up established companies via carve outs, exceptions and regulations that increased barriers to entry in industry.
"New industries cannot get a foothold in the industries that already have these giant companies. Even with regards to start ups aimed at establishing new industries, they are so burdened by a thicket of regulations that as somebody said, if he were a start-up entrepreneur now, he would need more lawyers than engineers… The government is doing a tremendous amount of damage and it is failing to help a very sick economy," he said.
Phelps' comments came one day after Robert Shiller, the newly named 2013 economics Nobel Prize winner, warned that global house prices might be overheating once more.
(Read more: Nobel Prize winner warns of 'bubbly' home prices)
—By CNBC's Katy Barnato