The US economy: growing but fragile


By Martin FELDSTEIN Professor of Economics at Harvard University


Professor Martin Feldstein explained that the US economy is generally doing well, but remains fragile. Interest rates are rising, quantitative easing will end, the budget deficit will increase, and eventually growth will slow. What will be the trigger?


Mr. Feldstein focused largely on the US economy and its political environment. Stating that he had been an advisor to presidential hopeful Jeb Bush, he criticized Donald Trump for un-presidential comments, but said that they are directed mostly at his political base. This is also something Ronald Reagan did, but he used a positive tone, while Mr. Trump is being negative to stoke the anger of his constituency. Overall, however, we must look at the policies and not his statements and rhetoric.
So far President Trump’s actions have mostly been reversals of campaign promises, especially in economic policy, where Congress has the final say in any case. Moreover, for international policy, Trump has a competent team. For example, there has been no fundamental change in US policy toward China, and he even concluded a deal for increased exports of US beef and services. The trade threats against South Korea, Japan, and Mexico have also proved hollow, as has the rhetoric on NATO. Most of this, however, is not reported by the media, since journalists generally dislike Trump.

« Like many Americans, I find President Trump’s behaviour, statements, tweets, and misinformation very un-presidential. But he is not speaking to folks like you but to his political base. »


Concerning the US economy, Mr. Feldstein finds the outlook positive but fragile. The US has moved beyond full employment and inflation is stable. However, very low interest rates are pushing up asset prices, with price earnings ratios higher than average. Treasury bond yields are also too low, while capitalization rates, commercial real estate, and other assets are overpriced. The question is what will trigger a decline. It is certain that it will happen eventually and that it will be contagious, reducing consumer spending and investment, and thus GDP.
GDP, however, is not measured correctly by government statisticians, who do not capture the value of free digital products such as Google maps, asserted Mr. Feldstein. It could be understated by as much as 2 percentage points, so projected growth figures of slightly more than 2 percent do not reflect reality.
The key is to look at consumption, which represents more than 70% of US GDP. Real earnings are up slightly and unemployment is low, so household confidence is stronger than the statistics indicate. The stock market is doing even better, house prices are rising, and the lower cost of capital is increasing investment. Therefore, growth will occur even if there are no changes in tax and regulatory policy.
The Federal Reserve Bank is also finally normalizing interest rates, with a third rise this year likely in September, according to Mr. Feldstein. Regaining credibility on interest rates is important, although they are still too low. The Fed is also reversing quantitative easing (QE) little by little.
While President Trump’s policies remain unclear in many areas, a good barometer will be whom he names to replace Janet Yellin as head of the Fed. He may turn to a non-economist, market-oriented person such as Gary Cohn. The challenge for the new head will be to act constructively if asset prices decline while interest rates are still low.

« A large decline in asset prices would reduce consumer spending and business investment, so I think our economy is very fragile. »


For Mr. Feldstein, the biggest concerns are tax and budget policy. The deficit is getting worse, with the debt to GDP ratio at 70 percent, double that of ten years ago. Counting on infrastructure to boost revenues is not credible, since most infrastructure is not private and does not generate revenue. Health care is another wild card. President Trump has a good chance of passing a bill, but the revenue implications are not clear. Meanwhile, defense spending, which now accounts for 3 percent of GDP, is heading toward 4 percent, and will add to the deficit. Cutting nondefense spending to compensate is controversial.
Congress drives tax reform, and it will likely insist that rolling back the top rates must be revenue neutral, but there are no plans to reduce deductions for mortgage interest and charitable donations. On the corporate side, the goal is to increase capital formation, productivity, and real wage growth.
Two parts of the tax plan may happen, according to Mr. Feldstein. The first is a cut in the corporate rate from 35 percent to about 20 percent, which would attract capital. While this seems beneficial, the revenue loss would be $160 billion, he cautioned. The second is a shift to a territorial corporate tax regime as elsewhere in the world, which would raise revenue and capital accumulation. Other tax ideas, such as a cash flow corporate income tax and border adjustment tax will not happen, so it is not clear where new revenue would come from to balance the budget.

« The big shift in central bank porfolios will have an important effect on increasing real long-term interest rates. In my sense, the markets don’t yet reflect that. »