Robert Rubin, former U.S. secretary of the Treasury, says the U.S. economy is still likely to “face enormous headwinds.” Speaking at CME Group’s Global Financial Leadership Conference in Naples, Fla., Rubin takes a look at the economic Rubik’s Cube of unemployment, fiscal deficits, currencies, trade and the prospects of putting the U.S. economy back together again.

Robert Rubin is at it again, trying to figure out the puzzle that is the U.S. economy. The man who played a leading role in many of the economic policies during the Clinton administration says that what this economy needs is a good dose of confidence and serious attention to policy on fiscal matters and public investment.

Even with some recent indications of improvement, growth is likely to be sluggish relative to post-Second World War recovery, and bumpy, with unemployment high for an extended period of time, Rubin says. Federal deficits are still on an unsustainable trajectory, and large state and local budget gaps must be closed.

“I think the prospects for the United States economy for both the short term and the long term are the most complex and uncertain of my adult lifetime,” Rubin says. “That obviously creates an extremely difficult decision-making environment for investors, for business people, for policymakers and for our people.”

Rubin notes that the government’s macroeconomic tools, fiscal policy and monetary policy may all have been pushed to the limits of prudence.

“I think the administration was right in proposing specific and limited measures that might be particularly powerful in generating economic activity,” Rubin says, citing the proposal for small-business lending.

The recently enacted year-end fiscal measures are estimated to have cost roughly $250 billion to $300 billion, or one percent of GDP in each of two years – counting only what was not expected to be done in any case, and attributing little cost to business expensing that just defers taxes in a near-zero interest-rate environment. The total effect of the stimulus remains to be seen.

While Rubin believes that an additional stimulus initiative tied to structural fiscal reform could be constructive, he says that a major new stimulus on its own is likely to be counterproductive. Piling sizeable new deficits on top of current debt could harm already troubled business confidence. “Substantial new deficits could also lead to sudden and unexpected disruptions in market psychology and, following from that, disruptions in the bond market,” he says.

Even if a major additional stimulus unassociated with subsequent fiscal reform worked initially, it could fail to generate ongoing momentum, given the enormous macroeconomic challenges, Rubin says. The debt-to-GDP ratio would be worse, and that in turn would increase the likelihood of market disruptions, forcing us to deal with them in worse circumstances.

He is also doubtful about additional quantitative easing, the Federal Reserve Bank’s plan to buy $600 billion of U.S. Treasuries. On the one hand, it could reduce already low interest rates, which in turn could stimulate consumption and investment. It could also weaken the dollar, promoting exports and strengthening the stock market. (However, so far at least, 10-year rates are higher now than they were before the proposal was either floated or formally announced.)

“On the other hand, even if the positive effects occur, they are likely to be quite limited,” he says.

“A weaker dollar could lead to dangerous competitive devaluations,” Rubin says., and those devaluations could lead to financial chaos, or restrictive trade measures elsewhere in the world. Commodity prices are already increasing as a result and could undermined the development of additional demand. But the most serious problem is that the new program has heightened existing concern that we might, at some point, monetize our debt to try to inflate our way out of our fiscal problems.

Confidence Boost

The current lack of business confidence also concerns Rubin, who points out that there is considerable strain between the administration and the business community. He believes that the administration should work closely with businesses and all other interested parties on regulations that offer strong protection, but which also factor in economic impacts.

With regard to trade, Rubin says new trade treaties could improve business confidence. But current account imbalances based on non-market exchange rates, subsidies and trade barriers pose artificial risks to U.S. producers of goods and services. “It seems to me it is in the interest of all the countries involved to find non-unilateral ways of resolving these issues,” he says. “To resort to unilateral remedies has the risk of creating trade wars that could be enormously harmful to all concerned.”

Rubin, who served in the Clinton administration from 1995 to 1999 and helped erase the U.S. federal deficit, recognizes the difficulties involved with today’s large and rapidly growing debt. He advocates that the administration and Congress work together to develop and enact the first phase of a serious deficit reduction program to take effect in two to three years, including room for public investment in competitive areas such as education, infrastructure and research.

Rubin notes that the politics of deficit reduction are enormously difficult, because the American people do not want tax increase or spending reductions that would affect them. He does believe that the 2001 to 2003 tax cuts for people earning more than $250,000 should have been allowed to expire.

“By not doing that, we sent a signal that we can’t deal with even the politically simplest and least difficult of budgetary constraints,” he says, adding that he agreed with extending tax cuts for people earning less than $250,000 by two years. Now he would work out of permanent solution in the context of a first phase of deficit reduction.

The most important challenge the United States faces, says Rubin, is moving from its current unsustainable fiscal trajectory. Without a trend change, business confidence will continue to be adversely affected, capacity for public investment will be constrained, and resilience for dealing with economic emergency will be restricted. Most dangerous and most disruptive, however, would be having the country developing significant deficit premia in bond markets that, in turn, could lead to a long period of slow growth, or worse.

Rubin believes there is hope, despite the gloomy picture and hurdles ahead. But it will take good policy and confidence. He says “an investment-led recovery,” similar to that which occurred in 1993, could provide a boost to consumption, and “this could build the needed momentum.”