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A US fiscal stimulus now would stoke inflation, crash the markets and cause a recession

  • A boost to aggregate demand would exceed noninflationary growth potential
  • Fiscal, structural and trade policies should first remove obstacles to faster growth
  • A fiscal stimulus now would stoke inflation, crash the markets and cause a recession, Michael Ivanovitch writes.
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When Friedrich Hayek, a Nobel Prize-winning economist and political scientist, was challenged in a television interview to give a simple explanation of price inflation, the Viennese aristocrat chose a plebeian simile: "It's like overeating and indigestion."

The interviewer settled for that because, apparently, the image was more vivid and evocative than the usual "too much money chasing too few goods."

I like Hayek's quip because it points to the pain that follows from exceeding the economy's capacity to handle rising pressures on available labor and (physical) capital resources. I also think that will help investment strategists understand the anxieties raised by the possibility that the White House and the Congress may soon agree on a budget-busting fiscal stimulus.

Here are some numbers to illustrate the feast and the hangover.

In the first half of this year, the U.S. economy was growing at an annual rate of 2 percent. Most people, including myself, are not happy with that pace of economic growth. We want more — and faster. But the sad truth is even that growth rate of 2 percent is more than the current factors of production (labor and physical capital) can deliver under conditions of non-accelerating inflation.

Learn from past mistakes

How come? It's simple: The stock and the efficiency of current labor and capital resources can only produce a noninflationary growth rate of 1.5 percent. And that's not new. That limited growth potential has been there last year, too, when the actual GDP growth was also 1.5 percent.

Would the last Friday's excitement about a 2.9 percent annual increase of average hourly earnings in September, and a decline of the unemployment rate to 4.2 percent, be a sign of increasing capacity pressures as the economy moved up to a faster pace of advance?

That's quite possible because economic growth has accelerated considerably since it bottomed out at 1.2 percent in the spring of 2016.

Now, it is easy to imagine what would happen if large personal and corporate tax cuts were unloaded in an economy that is already growing well above its noninflationary potential.

Take, for example, that 2.9 percent annual wage increase in September. Even with an exceptionally high, 1.3 percent, productivity growth in the nonfarm business sector in the first half of this year, that would give a unit labor cost increase of 1.6 percent. And that would be a significant shock to corporate profits, and equity prices, after an average 0.8 percent unit labor cost growth since the beginning of 2016.

That's where the trouble would start: Businesses would then move to raise prices to protect their profit margins, setting in motion the proverbial wage-price spiral as the fiscal stimulus and low credit costs continued to support household consumption, and residential and fixed investments.

The Federal Reserve, of course, would be in on the act at some point in that process, first proceeding carefully and gradually to avoid crashing equity markets — until it became clear that gentle gradualism would have to give way to a strong and prolonged credit tightening.

We would then have the entry point into a recession of unpredictable amplitude and duration.

Warm up to win the game

Is there any way to avoid this? Yes, there is, but that would be incompatible with election cycles and political demands of the moment.

The best solutions for a stronger and steadier long-term growth would be to use fiscal, structural and foreign trade policies to relieve and remove the physical limits to a faster noninflationary economic activity.

Here is an example. That 2.9 percent surge in nominal hourly compensations was obviously caused by a shortage of labor with the skills that were in demand.

We don't have enough manpower to satisfy the labor demand in spite of the fact that 13.5 million people last month were out of work or without stable employment. Some 5.1 million Americans were working part-time because they could not find full-time employment, and another 1.6 million quit looking for a job because they could not find a place to work. On top of that, 94.4 million people, or 37 percent of the active civilian labor force, were out of the labor market.

Think of a huge pool of labor supply that remains untapped while people who should know better keep pushing for interest rate hikes because of labor shortages. And then think of what fiscal and structural policies could — and should — do to increase the amount of manpower and the skills that are being demanded. Those policies would not only raise the stock of human capital, they would also raise labor productivity by broadening and upgrading the supply of skilled labor.

Fiscal, structural and foreign trade policies could also encourage business investments in plant, equipment and information technology, especially if they were to reduce incentives to locate production overseas for reasons of lower costs and tax liabilities.

All those policies should be part of patient and focused efforts to raise the noninflationary growth potential of the American economy to at least 3 percent — a short-lived nirvana we enjoyed in the late 1990s. But those policies are not quick fixes. They transcend the election cycles and partisan preferences, so it would be unwise to bet on them at this juncture.

Investment thoughts

Apart from serious damage to an already high public sector budget deficit (5 percent of GDP) and a huge and rising public debt (110 percent of GDP), large personal and corporate tax cuts would also raise cost and price pressures in an economy that is currently advancing faster than its 1.5 percent potential and noninflationary growth rate.

That prospect — if it were to materialize — would force the Fed to accelerate its process of credit tightening, leading, as always in similar circumstances, to a slowing economic growth and unavoidable recessionary slippages.

A correct, but highly unlikely, policy approach would be to maintain an economic growth close to the economy's current noninflationary potential. Starting from those initial conditions, fiscal, structural and foreign trade policies should be used to raise the stock and quality of human and physical capital that would gradually relieve and remove the economy's current limits to growth.

And you can take this to the bank: Tax cuts to boost aggregate demand — under present cyclical conditions — would lead to sharply rising interest rates and falling bond and equity prices. Fixed-income markets would begin to recover only after it became clear that short-term interest rates had reached the level that would slow down the economy and deflate cost and price pressures.

That, indeed, would be a serious case of Hayek's "indigestion," and a sad coda to a misguided effort to invigorate American economy. America needs to grow faster — much faster than is the case now — to remain relevant in the world of increasingly credible strategic competitors.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He 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 Business School.

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