Economist Fred Carstensen: GDP Up 2.5 - 3% Unlikely With Sequestration, Congress Inaction

by: Harlan Levy

Summary

GDP up 2.5 – 3% by 2016 is questionable with sequestration, Highway Trust Fund lapse, Congress’s inaction, global uncertainty.

Stocks overvalued until there is a real business investment with 2 – 3% inflation.

Household, student debt undermines housing; missing 3 million home purchases.

Economist Fred Carstensen is a professor of finance and economics at the University of Connecticut and director of UConn's Center for Economic Analysis.

Harlan Levy: How's the U.S. economy doing?

Fred Carstensen: It's doing OK, but we are well below what are potential is either in terms of total output or jobs.

We've got a lot of new people who have come into the employment market, and we're two to three million jobs below where we should be. We haven't created any net new jobs from where we were at the end of 2007, no jobs to accommodate the new workers in the workforce. That's why workforce participation is at historic lows. We still have a long way to go.

Many forecasts are positive. Some see growth coming up in 2016 to 2.5 or 3 percent. I'm a little skeptical of that because we still have huge problems with the Federal Highway Trust fund, which will run out of money in two more months. If that happens, and Congress fails to act, then hundreds of millions of dollars in capital projects will literally stop in their tracks, and others won't happen.

And we still have sequestration, $85 billion a year automatic across-the-board spending-cuts through 2021, which people have forgotten. That accounts for 1 percent of lost growth, and that means that the economy is growing on the order of 25 to 30 percent slower that it would have.

Plus, we have some very real threats on the horizon - the Highway Trust Fund, the situation in Iraq, which could blow up even more dramatically. We could see a significant spike in energy prices, gasoline prices. There's enough uncertainty in the world to make me more than a little nervous as to whether we can sustain the recovery.

Q: Inflation hit the 2 percent level recently. Is inflation a concern?

A: Inflation, what's that? There's no credible threat of inflation. There's no indication that the markets see an inflation threat. We would like to get a little bit more inflation. One of the reasons companies are sitting on so much cash is that there's very little penalty when there's no inflation.

What you'd like to see is inflation growing at 2 or 2.5 percent, maybe even 3 percent. Then you put a sizable penalty on those holding cash. It reduces the purchasing power of the cash that they're sitting on. Companies will find a way to use the money more productively to generate more of a return.

That would be beneficial for the overall recovery. We are clearly lacking business investment. One of the reasons the economy has not recovered as much is that businesses are not buying the new equipment, the new computer systems, the new machine tools at the historical rate.

We see that in negative productivity growth. Labor productivity is very much connected to the rate of business investment. We are 30 to 35 percent below the level of business investment we've seen in historic recoveries.

Q: Now that we've recovered the 8.7 million jobs lost in the recession, are the numbers deceptive?

A: There are two things to remember about the numbers: No. 1 is that our recovery has been in lower-wage positions. Even though jobs are back to 2008 levels, household income has not recovered. The current median household income remains almost 10 percent below its peak. That's because the quality of the jobs created over the last four years have simply been lower quality at lower rates.

In all likelihood we'll continue to see modest but positive job creation, but we still have a long way to go to get back to the 2008 kinds of employment, because we've added a lot of folks to the workforce, but we haven't created jobs commensurate with that population.

So job creation will creep along at a positive rate of 175,000 to 250,000 a month, but we're not going to see the 400,000 jobs a month that we saw in the 1990s and briefly in 2004 and 2005.

Q: How is housing doing?

A: It's very clear that housing has enjoyed a modest recovery, but the sector remains much smaller than it was in the period up to 2008. It's still 30 to 40 percent smaller, so an important part of our recovery is still effectively a drag on our economic performance. We still have a lot of people who are carrying enormous debt.

One of the things that is undermining our economic recovery is that not only are a lot of people dealing with housing debt, but there's student debt. A lot of college graduates are not creating families or buying homes, and that's undermining our national economy. We're missing about 3 million houses that haven't been bought, 3 million appliances that haven't been bought, That's a lot of demand missing from the recovery. Builders are not going to build houses that no one is going to buy. Appliance makers aren't going to make appliances that won't sell.

We have managed to create this Gordian Knot of economic problems, including a tremendous amount of debt and a pullback on demand. We're not investing in public-sector research and development, which historically has become more important as a basis for growth.

Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL), Instagram, Twitter (NYSE:TWTR), every single one of them really are derivative of public-sector research and development. That's where the core of these companies was developed.

The importance of the public sector has become progressively more important over the last 60 years because the technology that requires the participation of multiple disciplines has been increasingly carried through by research scientists in national research laboratories or in our major research universities. If you look at the role of MIT, the University of Wisconsin, the University of Illinois, which is where the basic foundation of the Internet was created, the Defense Department, we're simply not sustaining that sector, which is the basis for innovation.

Q: Are stocks too high?

A: I think stocks are overvalued. If I had stocks that are appreciating, I'd take my money and get out. Given all the uncertainty in the world, I just don't see what's holding up the prices we see.

Companies have been very effective in cutting costs, but cost-cutting is not a sustainable strategy for improving performance over the long term. There's only so far you can go in cutting costs. Eventually you're going to degrade quality or no longer find a way to squeeze out more margin. Also, when you're not buying equipment you're not getting depreciation. So your accounting profits may have gone up because you're not investing in the future of your business, but you're not getting that write-off against your income.

Competition requires constant improvement. Take Microsoft: It is a quasi-monopoly company with a historically strong position, but it is a really weak company in terms of the future in the opinions of experts I've talked to. It is not producing quality software. It is trying to make a transition to more hardware, and it continues to be important in terms of Playstation, but Microsoft is not a company that is delivering quality products. A lot of people have never upgraded their operating systems, because systems from HP are better. And Microsoft just announced it will no longer provide support for HP. A lot of companies may choose to switch to Apple or figure out how to avoid going to another Microsoft operating system, which people find badly designed, unreliable, and uncomfortable to use.

Q: How serious is income inequality?

A: Income inequality is one part of a larger issue in that lower-income families are not acquiring any assets. High-income households are buying the assets.

If you take all the wealth in the nation and get an average, we're possibly No. l among developed economies, but it's extremely concentrated in the top one tenth of a percent. If you look at the median, we're 19th among developed economies. We are in the bottom end. And it's conceivable that we will no longer be among the developed nations.

Q: You have such a grim outlook.

A: Well, I would be very surprised to see anything that will improve our economic performance, given sequestration, the failure to implement any coherent infrastructure development, the uncertainties in the energy markets, and the uncertainty globally in Nigeria, Iraq coming apart at the seams, Syria's questionable viability. All this breeds the enemy of enterprise. It makes everyone more cautious.

In addition to sequestration, which is costing us something on the order of 20 to 30 percent in terms of job growth, our failure to address our increasingly decrepit infrastructure imposes a tax on the economy north of $500 billion annually. We're talking about losing something like 1.5 percent in terms of economic growth when you add those two together. You're talking about growth being 40 to 50 percent lower than if we had any kind of coherent economic growth strategy on the national level.

I'm not sure that any time in our economic history we have pursued policies that inflict so much damage on ourselves. You'd have to go back to the era of the Great Depression to make any comparable assessment of the failure of the national government to meet its basic obligations to the national economy and the citizens of the country.

Q: So is it at all possible to change that political picture?

A: I don't think realistically there is much prospect that we are going to address these challenges in the next two to three years. The only thing that might change it is if we really change the national dialogue so we begin to talk in a serious and sustained way about how poorly we are performing against historic records and the performance of many other countries in the world.

Americans seem to be profoundly ignorant of how dramatically America's competitive position has deteriorated in the last 30 years. We are not spending enough to even maintain the infrastructure we now have. It's significantly inferior to what is now in place or being built in China, Europe, and Canada.

Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.