US economy: Blame misaligned policies, not structural flaws

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Community Job Center in the Brooklyn borough of New York City

Investors need not worry about naysayers' myriad structural flaws of American economy. Some of these problems do exist, most are fanciful, but none are currently responsible for America's Mediterranean style output gap.

The U.S. economy is held back by a misaligned policy mix: Excessive fiscal restraint and an ineffective monetary policy at a time when aggregate demand remains well below its noninflationary potential.

Jobs, incomes and credit costs are the key variables driving America's economic activity. All of them are in a dire need of more supportive demand management policies.

It is wonderful to see that 288,000 new jobs were created last month in a broad range of nonfarm business sectors. But that still left 9.8 million people out of work, 7.5 million people stuck in part-time jobs because they could not get full-time employment and 2.2 million people who dropped out of the labor force because they were unable to find a job.

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Adding all that up, we get an actual unemployment rate of 12.6 percent -- double the officially reported rate of 6.3 percent.

And there is nothing structural about this, even though there are sectoral and regional mismatches between the labor skills demanded and those on offer. A meaningful decline in this huge number of unemployed can only be obtained with a steady and sustained increase of labor demand as businesses expand their output to meet rising sales. That is what we have don't have enough of.

Weak incomes are a direct corollary to such a large labor market slack. The real disposable household income bounced back in the first quarter of this year, but over the last four quarters incomes grew at an average annual rate of only 1.3 percent.

Ask the Fed why the banks are not lending

How can one expect a buoyant household consumption (70 percent of U.S. economy) from these employment and income numbers?

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A puny 2.2 percent average annual growth of consumer outlays during the last four quarters is partly a result of households drawing down their savings to maintain their customary consumption patterns. Indeed, the savings rate, now down to 4 percent of disposable income, has been on a steady decline since the middle of last year.

And neither are we getting much help from a near-zero effective federal funds rate and massive monthly asset purchases that have expanded the balance sheet of the Federal Reserve (Fed) to a mind-boggling $3.9 trillion and the banks' loanable funds (excess reserves) to an equally extraordinary $2.6 trillion – an increase of 32 percent and 49 percent, respectively, from the year earlier.

All we got from that is a 4 percent increase in bank lending to households. People are increasingly turning to nonbanks, whose consumer loans are soaring at annual rates of 7-9 percent and represent 60-70 percent of total consumer lending.

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Somebody should perhaps find out why it is that U.S. banks prefer to keep $2.6 trillion at the Fed at an interest rate of 0.25 percent instead of financing car purchases at 4.2 percent or extending two-year personal loans at 10.1 percent.

Residential investments -- the other interest-sensitive component of aggregate demand that is directly influenced by jobs and incomes – have also drastically weakened since the middle of last year. They increased in the first quarter at an annual rate of 2.3 percent, practically collapsing after a hefty 15 percent annual gain in the second quarter of 2013.

The most frequently heard explanations that rising real estate prices and higher mortgage costs are the main reasons for the weakening housing demand are largely peripheral to the core issues of high unemployment and virtually stagnant real disposable personal incomes.

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I am not dismissing the negative impact of a 12.9 percent increase in real estate prices over the last twelve months, and a 100 basis points gain in mortgage rates. But, as important as these things might be, they literally pale into insignificance compared with the depressive force of high jobless rates and nearly flat incomes.

Tell the Congress to ease up on the purse

Faced with weak private sector demand, one might expect that the economy would get some help from stronger public spending. Unfortunately, the opposite is happening. While criticizing Germany for palming fiscal austerity on its recession-ridden euro partners, Washington is in fact following the German policy line. According to recent estimates by the nonpartisan Congressional Budget Office, a severe fiscal retrenchment is expected to cut this year's federal budget deficit to 2.8 percent of the gross domestic product (GDP), marking the fifth consecutive year of a sharply narrowing budget gap.

That is a laudable effort, but such haste in slashing public spending is the last thing we need when the economy is growing below potential and struggling with high unemployment.

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The U.S. Congress should allow the government to, as the White House says, "spend money on infrastructure to fill up the potholes" and attend to other worthy public services. More generally, a reasonable increase in public spending would go some way toward supporting demand, output and employment.

Investment thoughts

This discussion shows that there is nothing structurally wrong with the American economy that would degrade it permanently – as some observers seem to believe – to the position of a global growth laggard.

Yes, income inequalities have to be watched carefully, but the U.S. needs no lessons on this because its progressive income tax was introduced in 1862. The progressivity has been sharpened many times since, and the public debate of income inequality will probably heat up during the forthcoming election cycle.

Education, healthcare and a more enlightened approach to immigration are also issues of continuing concern for every administration.

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U.S. trade imbalances are another ongoing question of public policy. Clearly, the economy could benefit from a more aggressive enforcement of sound trade practices to even out the playing field for American companies and to protect their intellectual property.

But more than anything else, the American economy needs effective fiscal and monetary policies to narrow its large output gap and to stimulate employment creation.

Don't sell the U.S. short; its world-beating companies offer some of the best and safest investment assets you can find – anywhere.

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