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Op-Ed: There is a long campaign to put the US economy back on track

U.S. President Donald Trump addresses a crowd at Boeing's South Carolina facilities on February 17, 2017 in North Charleston, South Carolina.
Sean Rayford | Getty Images
U.S. President Donald Trump addresses a crowd at Boeing's South Carolina facilities on February 17, 2017 in North Charleston, South Carolina.

With the labor force growth of 0.9 percent and productivity gains of 0.2 percent, America's physical limits to noninflationary growth are currently estimated at a pathetic 1.5 percent.

As a result, we have an accelerating inflation in a slowing economy. Last year's growth rate of 1.6 percent was an entire percentage point below the economy's pace of advance in 2015. In spite of that, the core consumer prices picked up to 2.3 percent (from 1.9 percent), the Fed's core inflation target (private consumption expenditure index) accelerated to 1.7 percent (from 1 percent), and unit labor costs (the floor to medium-term inflation rates) shot up to 2.6 percent (from 2 percent).

And with all that, the U.S. structural unemployment rate now stands at 4.9 percent, which means that the 15.2 million people currently out of stable employment cannot reconnect with steady jobs without major structural changes to labor and product markets.

That is President Trump's key challenge. He might as well forget about his re-election bid, launched last Saturday in that airport hangar at Melbourne, Florida, unless he can rapidly and substantially increase the economy's noninflationary growth rate to get most of these 15 million people back to work.

I don't know exactly what he has in mind when he says that he inherited "a mess," but the economy is certainly the main piece of that story. And it is a structural mess that has to be addressed by structural policies because there are no quick demand management fixes.

The Fed has to watch inflation

The Fed can help the president to understand that correctly. America's official money managers can tell him that they did all they could to sustain demand, output and employment in a structurally unbalanced economy. But without any help from fiscal, structural and trade policies they could not deal with the declining volume and productivity of the country's human and physical capital.

That's why America's potential (and noninflationary) growth rate fell to 1.5 percent from 3.2 percent in the 1990s and then to 2.1 percent in the first decade of this century.

The above numbers on price and labor cost inflation clearly show the limits to any supportive action the Fed can offer in the months ahead.

We can't say much about the fiscal policy because the president says he will roll out his tax and spending program in late March. Until that time, one can only speculate about the scope and magnitude of these measures.

But we don't have to speculate about the binding constraints facing fiscal policies. We know what they are. The total public sector budget deficit now stands at about 5 percent of GDP, the primary budget deficit (deficit before interest charges on public debt) is 1.5 percent of GDP, and the public debt is rapidly increasing well beyond 115 percent of GDP.

Looking at these numbers, the president may well say again "what a mess!" Indeed, these numbers are very, very difficult to work with. But the president might be lulled into believing the "slam dunk" advice of the "deficits-don't-matter" crowd. Their idea is that the U.S. can grow (inflate?) its way out of this.

Fancy a piece of "America First?"

They may well be right on condition that the Chinese, the Europeans and the Japanese underwrite our expansionary fiscal policy. They owe us, don't they? We gave them, net, a total of $581 billion in trade surpluses as we bought $1.1 trillion of their goods last year. So, they should pitch in if they want us to keep spending and to have our markets wide open, shouldn't they?

Who knows? The president has scared the hell out of the German and Japanese trade freeloaders. They were the first to run to the Trump Tower in New York and then to Washington to make sure whether they heard right the "America First" story.

It's not surprising they got scared. Look how they are paying us back. Last year, Japan ran a $69 billion trade surplus with us while dumping $31.6 billion of Treasury securities. Over the same period, Germany got out of us a $65 billion trade surplus and bought only $7.6 billion worth of Treasuries. They think they can get away with this? Not under Mr. Trump.

It's OK if you want to see this as a light-hearted takeoff on "The Art of the Deal," but please do take this seriously: With the initial inflation and fiscal conditions we now have, a huge pressure on our capital markets to finance a mega stimulus would send the bond vigilantes heading for the hills and would put a crashing end to the equity markets' Trump rally.

Why? Because the Fed will not be able to accommodate that. The Fed is poised to resume its interest rate hikes, and it would be unwise to believe the bromides that the Fed will do that "gently and slowly." Once the tightening process gets under way, markets will be expecting the next move, because inflation will not be going down in an accelerating economy.

Structural and foreign trade policies are equally complex, but the scope for policy action there is much bigger than in the monetary-fiscal policy mix.

Reasonable deregulation measures to improve market efficiency can make a significant contribution to economic growth. Healthcare, education and labor market policies are also essential to increase the volume and quality of human capital – a key condition to a more productive labor force and to an increasing growth potential of the economy. Also, adjustments to the corporate tax code are an important part of foreign trade policies, and so are revisions to unbalanced trade agreements.

Investment thoughts

The U.S. economy needs a broad-based realignment of demand management, structural and foreign trade policies to raise its growth potential from a dismal 1.5 percent. That is a long and a very difficult mission in view of binding constraints facing monetary and fiscal policies.

The only unknown about the Fed is the pace and magnitude of interest rate increases.

The intended tax cuts and spending programs will not be budget neutral. That poses serious risks to financial markets, economic growth and employment creation, because the Fed will not be able to accommodate Treasury's rising financing needs at unchanged credit conditions. Bond markets are quite vulnerable. Equities are less so, provided portfolios are trimmed for values that will resist in a credit tightening environment.

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