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A business recession looms: Reform of business taxes, regulations will cure it

The May jobs report was a shocker, with nonfarm payrolls up only 38,000 and private jobs up a mere 25,000. A lot of investors and economists are making the case that this was a weird, one-off, statistical glitch, and that stronger employment is on the way. They may well be wrong.

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If you smooth out the numbers with a three-month moving average, job increases have been slowing for five months. The three-month pace last December was 281,000 jobs. In the May report, the pace nosedived to 107,000. The unemployment rate fell to 4.7 percent, but that's largely because 458,000 people left the labor force.

This spells trouble for the economy. And if you step back and look at the whole business sector, a case can be made that the U.S. has been in a mild business recession for as much as a year, if not longer.

Take, for example, business fixed investment in equipment, software, plants, buildings, and so forth. This has been slowing for six straight quarters, and even went negative in the first quarter on a year-on-year basis.

Behind this business-investment slowdown, the broadest measure of profits from the GDP accounts, which very closely tracks IRS profits, has been negative for the past three quarters measured year-on-year. In fact, this slump began in the second half of 2014, almost two years ago.

Profits are the mother's milk of stocks and the lifeblood of the economy. While so many people obsess about the Federal Reserve, the reality is that stocks have been flat over the past year as profits and business investment have been weakening.

Another point: Core capital goods, including orders, shipments, and backlogs, have turned negative over the past three months and across the past year. This is a proxy for business investment, and it's not a good omen.

Finally, the closely watched ISM reports for manufacturing and services are barely above 50. In other words, they point to the front end of a recession. On the manufacturing side, key indicators like production and employment are below year-ago levels. New orders are flat. On the services side, the overall index is below year-ago levels, as is employment and new orders.

Many financial folks concentrate on consumption rather than business indicators, clinging to an outdated view that consumers are 70 percent of the economy. To be sure, consumer spending and housing are rising modestly. But new research by economist Mark Skousen of Chapman University shows that if you look under the hood of the GDP accounts, you will find that the intermediate stages of business production and services, including business-to-business activity, account for 50 percent of overall output. That's higher than consumption, which runs about 40 percent.

As a result of Skousen's work, the Bureau of Economic Analysis has created a new "gross output" measure, which is published with a lag. This GO measure tells us a lot more about the inside workings of the economy. And according to Skousen, 80 percent of all employment actually comes in the early and intermediate stages of business activity.

So let this be a warning. The overall economy is not yet in recession. But the business economy has been slipping for quite some time. And if falling profits and business investment continues, the jobs slowdown will follow suit -- if it hasn't already.

As for Fed watching, in this environment the Fed should stay put. No rate hikes. The time for raising target rates was back in 2011, when QE2 drove the consumer price index up to 3.8 percent. That's when it should have increased the target rate by a percentage point or so. If it had, it would have gotten back to Stanford economist John Taylor's rule. We would have all been better off for it.

But now is the time to turn away from monetary policy and focus instead on fiscal solutions to the ailing economy. Slashing business tax rates to 15 percent for large and small companies and overturning burdensome regulations is what the economy needs to get out of the doldrums.

That would bring business investment back. The U.S. would be the most hospitable investment destination in the world. America would win the global race for capital. Cash would be put to work in productivity-enhancing investments. And the economy would grow by 4 or 5 percent for years.

Real interest rates, reflecting higher economic returns, would rise as a sign of economic health. And then the Fed could normalize its policies by following market rates higher.

For a time, the dollar would jump, again reflecting market forces and not currency manipulation. Then the G-20, with strong U.S. leadership for a change, could coordinate currency values and stability.

That's my vision. Alas, we're going to have to wait until next year.

Commentary by Larry Kudlow, a senior contributor at CNBC and economics editor of the National Review. Follow him on Twitter @Larry_Kudlow.