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Why America’s economic engine is stalled

One of the most important sentences on the topic of economics in recent memory was written by a futures trader, not an economist. In a February blog post, Cronus Futures Management co-founder Kevin Ferry highlighted the essential problem for U.S. economic policy: "Tax law skewed toward capital over labor fosters excess capacity that makes a credibly high inflation expectation target out of reach."

Don't be misled by the language in his statement. Mr. Ferry is as far from a Marxist as it's possible to be, which just shows you how far the pendulum has swung. When financial industry professionals are complaining that profits are growing at the expense of labour, creating excess production that heightens deflation risk and squelches growth, things have to be pretty bad out there.

In fact, they are. The American economy currently makes more products, and provides more services, than the American people can afford to buy. This is best illustrated by the output gap, which measures current economic activity relative to an estimate of what the economy could be doing if it were operating at full speed. In nominal terms, the Congressional Budget Office estimates that the output gap is currently 2.73 per cent.

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A growing number of economists argue that a re-distribution of wealth is necessary to increase demand and close the output gap. Mr. Ferry's arguing from the other side – there's too much supply rather than not enough demand. The scenario he seems to be asserting is that corporate tax cuts, combined with job-killing technological progress and the Fed's monetary stimulus programs (which allowed corporations to refinance debt at lower rates and boost profitability) allow too many unfit companies to remain in business. Given the lack of aggregate demand, they would have failed under normal circumstances.

If Mr. Ferry is right, what we have is an oversupply of goods and services while overall corporate profitability remains, for now, strong. The big economic problem with this is the lack of corporate incentive to invest in expansion. The investment that does occur is to increase efficiency in order to maintain profits despite downward pressure on prices.

Increased efficiency, of course, means that fewer workers are necessary, so they can be fired in order to increase profit margins further. This is the spiral the Americans are in. The Fed may have prevented deflation, but it hasn't succeeded in raising inflationary expectations.

The current clown show in Washington makes it feel pointless to discuss viable policy U.S. options – Congress couldn't agree on a bill to supply bottled water to the chamber, never mind an economic plan.

But if and when the deadlock eases, at some point investors can expect a tougher corporate environment that reduces overall supply.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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