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US needs a proper mix of fiscal and structural policies

President Barack Obama meets with President-elect Donald Trump (L) to discuss transition plans in the White House Oval Office in Washington, U.S., November 10, 2016.
Kevin Lamarque | Reuters
President Barack Obama meets with President-elect Donald Trump (L) to discuss transition plans in the White House Oval Office in Washington, U.S., November 10, 2016.

Bond market vigilantes would love that. Maybe they are even secretly hoping that their wishes—stable real returns on their fixed-assets—will be met.

Here is what they are telling us now. After an expected trading correction, the yield on the benchmark ten-year Treasury note finished at 2.42 percent last Friday, slightly below the level where it opened up this year, and nearly 20 basis points below its recent peak of 2.59 percent in mid-December 2016.

That is remarkable bond market resilience in view of swelling torrents of dire warnings about inflationary policies of the incoming administration. These warnings are alleging that price stability will be gravely damaged by loose fiscal policies,rising budget deficits, the end of cheap imports (resulting from imaginary"trade wars") and labor shortages.

And, to make matters worse, Fed officials are now adding their "forward guidance" with speculations about the number of interest rate hikes in the coming months.

These naysayers apparently want us to think that the bond market vigilantes are dozing off and setting themselves up for a very rude awakening. But is that really the case?

Watch and wait

The answer crucially depends on the nature of the future fiscal stimulus, and on the resulting mix of monetary, fiscal, structural and trade policies.

At the moment, however, nothing specific can be said about that because we don't know exactly any of these policy programs that will be presented and pursued by the new administration.

But we do know the key parameters the new fiscal policy will have to observe – if the Congress and the White House want to avoid raising budget deficits and public debt.

Here they are. America's consolidated public sector budget deficit is currently estimated at 4.4 percent of GDP, and the gross public debt, at this writing, kept flashing on the national debt clock at $19.95 trillion, or 106.4 percent of GDP.

If the new administration wants to stop and reverse the growth of public debt, it cannot afford any increase in current budget deficits. Consequently, any new fiscal stimulus measures must be deficit-neutral. That is technically possible by rearranging national priorities.

In addition to that, the primary budget (public finance accounts excluding debt interest charges) must be brought into a substantial surplus and kept in that position until the public debt is down to 50-60 percent of GDP. And that's a long way to go since the primary budget deficit is now slightly below 1 percent of GDP.

All these fiscal parameters are binding policy constraints.Ignoring them would only aggravate already stretched public finances, and would inexorably lead to rising bond yields – i.e., rising interest charges on a huge, and increasing, public debt.

Such a fiscal policy would also create serious problems for the Fed and the economy as a whole. Indeed, any attempt to monetize the increasing public debt would lead to rising inflation expectations – i.e.,falling bond and equity prices – and a recession of ex-ante unknowable amplitude and duration as the Fed is forced to reduce the money supply.

The upshot is that the fiscal policy of the incoming administration has very little room to maneuver. To stabilize asset market values, and to support business and consumer confidence, the new fiscal policy would have to be (a) at least deficit-neutral and (b) to work in close coordination with growth-enhancing structural reforms.

Education and tax incentives

These structural reforms are any measures designed to create more efficient and competitive markets for labor, goods and services. They should remove structural obstacles to a faster potential and noninflationary growth which currently stands at a dismal 1.6 percent.

The objective would be to increase the volume and quality of human and physical capital. Here is an example of what that means in the situation we are facing now.

The labor market report for last December shows that the labor supply (aka labor participation rate) has been stuck at 62.5 percent forall of 2016.

So, even at a growth rate of 1.5 percent in the first three quarters of last year, we are experiencing labor shortages that have kept, during the same period, nominal labor compensations increasing at a rate of 2.7 percent. And there is worse: a -0.1 percent decline in productivity growth, over that interval, has led to a 2.8 percent increase in unit labor costs – a floor to medium-term inflation rates.

We have labor shortages? No way, as the president-elect likes to tweet. At the latest count, we have 5.6 million people working part-time because they cannot find full-time jobs. And then we have 1.7 million people who are virtually out of the labor force – they are so discouraged that they just quit looking for a job.

Bringing these 7.3 million people back into the labor force-- and that would be part of structural labor market policies – would make a world of difference.

Yes, I hear you say that they don't have the skills that businesses are looking for.

Train them – and that would be another measure of structural policies. That would make them more employable and more productive. And to make them even more productive, use tax policies – one more structural measure – to stimulate business investments in order to outfit the labor force with best-practice technologies.

Sum it all up: Increasing the volume and the quality of human and physical capital could easily bring back a 3.0-3.5 percent potential (and noninflationary) growth rates of the 1990s.

Investment thoughts

A proper combination of fiscal and structural policies need not lead to rising budget deficits and public debt. If adequately designed and implemented, these policies could substantially raise the economy's potential growth rate and lead to faster noninflationary growth, lower budget deficits and, in time, to the declining public debt.

Don't hold your breath for that? Maybe, but it would be a real shame if the Republicans missed this unique opportunity to tune up America's Formula One economic engine.

Bond market vigilantes – and the Fed – should hold the fire until we see the fiscal and structural policies of the new legislative and executive authorities.

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