The Fed, not the election, will decide US economic future

As always, the economy is the central issue of the unfolding U.S. election campaign. In the weeks and months ahead, we shall be hearing about the candidates' economic programs, focusing on jobs, incomes, public finances and international trade policies.

To understand the limits, or the pure wishful thinking, of these programs, we have to see the binding constraints the U.S policies face in these areas.

People are yearning for a better economy and a rising standard of living. Primaries show that the "same old thing" message and its proponents have serious problems. Tough contests lie ahead. Votes have to be won with the proverbial "meat and potato" issues and a country at peace.

So, let's start with the room to maneuver in U.S. fiscal policies.

A 'tight fiscal corset'

The initial position here is quite difficult. The budget deficit last year ended up at 4.5 percent of GDP, compared with budget deficits of 1.9 percent of GDP in the euro area and a 1 percent of GDP in China. No significant improvement in U.S. public sector accounts is expected this year or next.

What would that significant improvement have to be? We need a substantial and sustained surplus in our primary budget balances (i.e., budget position before interest rate charges on public debt). But instead of a surplus, we are now running a deficit of about 1 percent of GDP.

Under these circumstances, it is impossible to stop, let alone reverse, the growth of our gross public debt reaching 111 percent of GDP – and counting.

Keeping these constraints in mind, one can easily see the difficulty of income redistribution ideas: "revenue neutral" tax hikes on the One Percent and a corresponding tax relief for low- and middle income-earners – even if the future political composition of the U.S. Congress were to allow such policies.

What to do, then? The best I can see is to bear down on budget deficits and public debt by raising revenues (and rigorously controlling government spending) through steady and non-inflationary economic growth. I know that many of you will laugh this off, because you think that such a "tough love" election message would be a political suicide.

You may be right. But ignoring the binding parameters of our fiscal position will open the door to the snake-oil sales people when they begin to flood the media with "simple and easy" tax code changes and barriers to trade that would "eliminate our public debt" and keep everybody happy.

Until we wake up with deficits the rest of the world may not be willing to finance. That would leave the Fed with another round of huge monetary creation, accelerating inflation and a sinking dollar.

Exaggeration? Here are some numbers.

In the year to March, foreign official borrowers (central banks) reduced their holdings of our Treasury's debt by 1.6 percent, and their purchases of Treasury's most liquid short-term assets dropped a whopping 17 percent. Over the same period, even Japan and China – countries that accounted for 57 percent of our total trade deficit in 2015 - reduced their stock of our IOUs by 7.1 percent and 1.3 percent respectively.

Please note, Japan and China account for 40 percent of our Treasury debt that is held overseas. And we want to hit them with higher import tariffs?

A new 'art of the deal?'

If we want to hit someone running the second-largest trade surplus (after China) with the U.S., we should look at Europe. They are taking a cool $170 billion (net) out of our domestic demand, most of it accounted for by Germany's surplus of $74.2 billion, which exceeded last year our deficit with Japan by 8.2 percent.

But, who knows, we could get away with a new "art of the (trade) deal," if you believe the bromides of those commanding prime time on our financial networks, that even if foreigners dumped all of the $6.3 trillion of Treasury debt they are now holding that would just register a "few seconds" blip on the trading screens.

Now, who would have to pick up these $6.3 trillion to prevent that "few seconds-long" collapse of the Treasury market? It's a buyer of last resort called the Fed, which is already holding $3.9 trillion of high-powered money (a.k.a. the monetary base or M0) – 4.5 times the pre-crisis amount, an inflation bombshell that, to paraphrase one of my former Fed colleagues, would set the dollar going the way of your favorite peso.

So, let's stop here. I don't like extrapolations of current conditions into unknowable future catastrophic scenarios for a resourceful country like the United States.

Indeed, we have plenty of means if we have the wisdom and the political courage to stop bleeding (you know what I mean?) and to rearrange out national priorities (a.k.a. our budget). That would be the greatest contribution our future leaders could make to all of us, and beyond.

I hope they will do that. Education and vocational training are one of the areas where we could make a difference to our economy by improving the quality and the supply of our human capital. That would (a) raise our productivity, (b) increase the rate of our potential noninflationary growth, (c) hold our production costs down, (d) bring back home some of our manufacturing from abroad and (e) reduce our huge trade deficits that are now taking an entire percentage point of our GDP growth.

Unfortunately, America's college enrollment is on a steady decline, especially for low-income groups. Student loans are now estimated at $1.3 trillion, more than one-fifth of which is technically delinquent. Our influential media are reporting that an average U.S. college graduate is stuck with about $35,000 in education-related loans.

President George H. W. Bush pledged that he would be an "education president." Maybe I missed something, but I have not heard a similar commitment from our leading presidential contenders on education, science and technology that will determine the future of our country. That, without any doubt, would keep America great.

Investment thoughts

Voters and their elected representatives will have to decide on the possibilities of revenue-neutral income redistribution with an appropriate adjustment of our tax code. That's the only major fiscal policy change that I could see, but your guess is as good as mine whether the future Congress and the White House will be able to agree on that. At any rate, that would also require a strong, grass-roots political commitment of the American people.

The other fiscal change that I could see is an equally politically contentious rearrangement of national priorities within the federal budget. Education, science, technology and nation's healthcare should be, in my view, top of that list. However, to keep all that revenue-neutral, somebody else's ox would have to be gored. That is tough, because the powerful Beltway will fight to the last man.

The Fed is all we have left. As in the past, the U.S. money managers are the only credible force in America's economic policy making. But you would not be able to tell that as the G-7 leaders were patting each other's back in Japan last week by praising their collective economic achievements.

Not a word about the Fed , the ECB and the PBOC's brave and smart support of the economies egregiously mismanaged by American and European (i.e., German) leaders.

Count of these three central banks to keep us afloat, unless Germans decide to definitively scuttle whatever is left of the EU and of one-fifth of the world economy.

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