London, 26 August 2011

As 2010 drew to a close, expectations for a more vibrant economy in 2011 ran high, especially in the US. The stunning reversal of control of the US House of Representatives had inspired hope that a “bi-partisan” government, more attuned to competing arguments on both sides of major policy issues, would be able to agree on general objectives, even if concurrence on specifics might remain elusive.

Adding to the late-2010 optimism, the sobering report from the special commission charged by President Obama to develop strategies for addressing the government’s long-run budget imbalances won surprising bi-partisan praise and support. Count us among those who saw the Bowles-Simpson commission’s recommendations as a promising framework around which substantive actions could be erected. Then came further evidence that a more cooperative spirit might be taking hold.

The president and the soon-to-be Congressional leadership agreed to extend for two more years the so-called Bush tax cuts that had been set to expire last December, to extend the Emergency Unemployment Compensation (EUC) program for another year and to cut the employee Social Security “contribution” by two percentage points.

Altogether these measures prevented a sudden surge in taxes that would likely have been lethal to the economic expansion. Indeed, even though the payroll tax “holiday” would provide only a temporary boost to disposable income and spending, conventional macroeconomic models foretold a potent lift to economic growth in the first quarter of 2011.

Unfortunately, other developments intruded. Even before workers could determine how they might spend their temporary windfall, soaring energy costs made the choice for them. Thus, even though an 8.3% (annual rate) surge in personal income in Q1 supported a 6.1% increase in consumer spending, higher prices of foods and energy cut the purchasing power of that spending to generate a modest 2.1% advance in real consumption.

Higher prices took an even heavier toll on spending in the second quarter, and throughout the first half of 2011 Mother Nature unleashed a barrage of winter storms and springtime tornadoes that played havoc with the economy for months. As if the natural disasters at home weren’t enough, disruptions caused by the earthquake that struck Japan in March left the entire auto industry in disarray for months.

Each of these “shocks” took their toll on economic growth in the US, but their effects were beginning to wane and the revival of activity that we had expected in the second half of 2011 seemed to be underway in July. That month, US industrial production rose 0.9%, retail sales increased by 0.5% and, most encouraging of all, private sector payrolls scored their biggest year-on-year advance in nearly five years.

But now in the waning days of summer the anticipated revival seems little more that a pipe dream. As Europe has struggled without much success to resolve the debt crisis confronting the euro zone periphery before it infects the continent’s financial system, the fear of contagion has morphed into a general crisis of confidence about policy on both sides of the Atlantic. The trophy for policy ineptness remains in play but, alas, there is no lack of contestants.

In the US, the formulation of a credible fiscal strategy has proven especially elusive. By failing to endorse and promote the Bowles-Simpson recommendations, President Obama squandered his best chance at historical fiscal reform. Reforms of both the tax system and the social welfare programs will ultimately be adopted and both are likely to promote faster economic growth and rising employment. Sadly, such reforms remain unlikely in the near term.

Instead, the president promises a set of “timely, targeted and temporary” initiatives. The new plan is likely to include continuing the EUC program and extending the payroll tax cut for another year. But fiscal policy measures that do little more than transfer income from one group or generation to another are unlikely to vault a moribund economy onto a sustained higher growth trajectory. A more credible brief can be made for public infrastructure investment, but undertaking projects of sufficient scale and scope requires careful planning and diligent project execution.

That only about $50 billion of the $787 billion fiscal stimulus program has found its way into such infrastructure spending illustrates that desirable public works projects are poor counter-cyclical measures. Moreover, knee-jerk resistance to any new program will likely ensure a hobbled fiscal policy, leaving the economic-adjustment burden on the Federal Reserve.

Ends --

David Resler, Contributing Economist, Nomura.

The report can be accessed electronically via www.nomura.com/research or on Bloomberg (NOMR)