An upward inflection point in economic and market performance in recent months contributed to a gradual improvement in the U.S. labor environment....
An upward inflection point in economic and market performance in recent months contributed to a gradual improvement in the U.S. labor environment. This is welcome news, but economic conditions don’t point to a sustained improvement in business investment or long-term GDP growth rates. Helping the outlook in recent months, the European Central Bank provided two rounds of unlimited loans to banks in the euro-zone, reducing the risk of a melt-down in the global financial system. And bank regulatory policy has been relaxed markedly in Europe, the U.S., and China, providing impetus for growth in private sector credit and debt in 2012. These policies lowered bond yields in Europe’s weaker economies and lifted global equities. Furthermore, February auto sales were strong, in part due to the ready availability of financing, but auto and auto-parts production is just 2.6% of the economy. Jobless claims have fallen substantially, reflecting fewer layoffs as businesses finally stabilize at reduced levels after the 2008-2009 crisis. However, growth in U.S. personal income remains weak, pointing to a material slowdown in first quarter GDP from 3% in the fourth quarter. And durable goods orders apart from autos have slowed from the fourth quarter. Many problems weigh on the outlook. Uncompetitive Tax Rates The U.S. tax code remains in shambles. The 35% corporate tax rate is the highest in the world. Reform should have been at the top of the Executive Branch’s policy agenda, yet the issue has languished. Many individual tax rates are scheduled to rise at year-end including the marginal rates for all tax brackets and the alternative minimum tax rate. In 2010, uncertainty about the impending tax increase slowed growth and investment materially, contributing to a “soft patch” that depressed 2010 growth until the legislative fix in December 2010. The same process is at work in 2012, with the possibility that businesses will hold back on investment and hiring until the threat of a year-end mega-tax increase is addressed. Federal Budget Woes The U.S. federal budget process is also in shambles, risking more downgrades of the U.S. credit rating. The $16.4 trillion statutory debt limit will be exhausted late in 2012, creating a replay of the August 2011 debt-ceiling political confrontation. The Obama administration’s FY2013 budget proposal accentuates Washington’s budget chaos — even OMB’s rosy deficit estimates (fast growth, low interest rates, strong tax collections) show huge and growing deficits and higher debt-to-GDP ratios. The budget dynamics suggest the deficit will be worse, as partly reflected in CBO’s latest re-estimate of the OMB budget. The Encima Global forecast is that current policies will push the U.S. marketable debt-to-GDP ratio above sustainable levels. Contributing to the problem, the accelerating retirement of the post-World War II baby boom will add to Social Security and Medicare outlays while reducing the output from many of the economy’s most skilled workers. Federal debt is now 70% of GDP and is on a course to top 100% of GDP unless substantial new spending restraint is developed. Monetary Trouble Ahead Adding to the risk, the Federal Reserve’s massive buyback of long-term government bonds has substantially shortened the effective maturity of the national debt. This means the deficit cost of rolling over the national debt will be elevated once interest rates return to more normal levels. Artificially low interest rates have become embedded in the economy beyond the Fed’s impact on debt maturities. This artificially low price of credit inherently causes rationing and shortages, channeling capital away from new, small, and risky borrowers and toward government and big business. This comes at the expense of savers and sets a precedent for future Federal Reserve intervention into the economy, bond markets, and capital allocation. This combination reduces the economy’s free-market dynamism, one of the key factors holding down the level of investment in the economy. Artificially low interest rates have also contributed to dollar weakness and the escalation of gold and commodity prices. Gasoline prices are rising again. CPI inflation remains near 3%, a level that impedes economic growth. 
Problems in Europe In addition to daunting U.S. problems, Europe faces several cautions after the good news late in 2011 — which included regulatory forbearance in favor of weak banks, European Central Bank (ECB) rate cuts, ECB three-year bank loans, a sharp decline in peripheral bond yields, and the late 2011 rise in European bank stock prices. Europe’s fiscal plan, a necessary step in addressing the huge overhang of government debt, hinges on forcing a euro-zone charter change to entrench deficit reduction. This probably won’t work well because the deficit rules will be difficult to enact across the euro-zone. Most of the countries are seeing fiscal deterioration due to the recession, and austerity programs based on tax increases are worsening the deterioration. Europe’s fiscal plan is neutral regarding whether governments reduce their own spending or add taxes on their private sectors. Since most governments prefer the latter, the impact of the proposed change in fiscal rules on private sector confidence and investment is limited. Growth programs based on labor market liberalization and reduced government spending are preferable for Europe’s private sector, but that approach isn’t gaining traction. Spain has already raised its national deficit expectation and is seeing state and local governments raise their own deficit expectations, making clear that Spain’s debt-to-GDP ratio will rise much higher as debts are acknowledged. Just as regulatory forbearance became a key issue in 2011, fiscal forbearance — avoiding a negative regulatory response to fiscal deficit violations — will have to occur and will cause a confrontation with Germany. Like the U.S., Europe faces difficult elections in 2012. The French election creates major economic uncertainty in both the first and second rounds (April 22, May 6). The socialist party challenger, François Hollande, leads in the polls and has rejected Germany’s fiscal targeting and promised a major increase in France’s already-high top marginal income tax rate for upper-income taxpayers. Greece is expected to elect a new parliament and prime minister in early May. This may deepen Greece’s governance problems as Greece begins to comply with the latest austerity program. Greece completed its debt restructuring but will be saddled with a mound of non-restructurable debt to the ECB, other European central banks, the IMF, EU, and the holders of the new foreign-law bonds. Greece is reliant on more EU and EFSF aid to cover its still-large fiscal deficits and debt service. For now, we expect Greece to maintain the euro and remain in the EU (this is Greece’s and Germany’s strong preference). But, as private sector conditions in Greece deteriorate and the cost to Germany of Greece’s huge government sector rises, Greece may still be pushed toward exiting the EU and leaving the euro — unless strong new Greek leadership emerges or a European economic boom bails Greece out. A near-term turnaround is unlikely. Europe is falling into recession, with Germany’s growth data deteriorating. Stronger U.S. growth will help some, but probably won’t be strong enough to lift Europe in 2012. In sum, there’s been a welcome rise in near-term sentiment in the U.S. and Europe and in global equity markets, but deep problems weigh on the growth outlook. There’s little optimism that proven growth techniques — sound money, low tax rates, restrained government spending, constructive regulatory policies — are gaining traction, leaving the longer-term U.S. and global growth outlook muted.
