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El-Erian: A recipe for continued economic momentum

May 6, 2013: 6:45 AM ET

Friday's virtuous news cycle needs to continue if the U.S. economy is to overcome headwinds from Congressional dysfunction and Europe's malaise.

By Mohamed El-Erian

jobs-050313-620xaFORTUNE -- Most newscasts led their Friday evening shows with the record highs for the stock market and a monthly jobs report that exceeded expectations. Both bits of good news speak to an economy that continues to heal gradually. The question now, and it is an important one, is whether positive interactions among the two will create sufficient momentum for the U.S. economy to attain escape velocity.

Let us start with what matters most to the immediate well-being of the U.S. and, indeed, the global economy -- the country's ability to create jobs and sustain satisfactory wage growth.

Friday's job report outperformed (albeit muted) expectations in three important and hopefully repeatable ways:

  • With 165,000 new jobs and with revisions to prior totals, the three-month average gain now stands at almost 212,000 per month, or close to the threshold that triggers a stronger set of mutually-reinforcing endogenous dynamics.
  • The unemployment rate fell to 7.5%, its lowest level since December 2008, and it did so due to a good reason (more jobs) rather than yet another decline in the labor participation rate (which continues to languish at 1979 levels).
  • The number of long-term unemployed fell below 4.4 million, suggesting that the labor market is doing a better job at re-engaging those facing the highest risk of skill atrophy.

Of course, there is still a lot to worry about given the depth of the unemployment crisis triggered by the 2008 global financial crisis.

The sector composition of job gains is far from ideal. Earning growth is hesitant. Many people still struggle, with vulnerable segments of the population battling poverty and alienation (including among the youth, the long-term unemployed, and those lacking sufficient education and training).

MORE: Why the jobs report calls for more Fed action

Nevertheless, recent job gains are real, and they constitute a notable step in the right direction. This last observation is consequential for the linkage to the second bit of good news on Friday, the record highs for the Dow Jones, S&P 500, and even stock markets abroad.

Friday's jobs report increases, albeit just marginally right now, the possibility that improved economic fundamentals would validate today's highly-assisted financial prices -- and, with that, significantly enhance the possibility of an endogenous, self-reinforcing virtuous cycle.

We should not underestimate the potential contribution to national well-being of the interactions between an improving labor market and financial markets that are buoyant for the right reasons. Together, they provide the potential for the private sector to overcome the headwinds from dysfunctional Congressional politics and European recession.

By improving both income and wealth prospects, this combination entices healthy corporate and household balance sheets around the world (and there are quite a few of them) into win-win productive activities. In the process, the U.S. economy would transition from "assisted" to "genuine" growth; and the global economy would find better footing. The alternative is persistently high unemployment that becomes more structural in nature, and renewed risks of financial disruptions.

MORE: Buffett worries about Fed's 'huge experiment'

Remember, rather than driven primarily by fundamentals, financial markets reflect today the impact of hyper-active central banks seeking to promote growth using partial and imperfect tools. In the process, these institutions have ventured deep into experimental territory; and the longer they stay there, the higher the risk of collateral damage and unintended consequences.

While economic outcomes have repeatedly disappointed, even falling short of policymakers' own expectations, investors have nevertheless become conditioned not just to react but also to front-run any and all expected liquidity injections -- including in Europe where the President of the European Central Bank has engineered a massive broad-based market rally by simply announcing its intention to do "whatever it takes" (and asserting "believe me, it will be enough").

With such dynamics, investors end up taking more risk at ever higher prices. Some are comfortable betting more of their future well-being on the central bank liquidity wave, believing that these institutions have no choice but to increase their activism in coming months. Some doubt the longer-term robustness of the wave but are happy to ride it for now, believing that they can exit markets quickly if it starts to break. And others are simply victims of industry and media hype.

This is why more people are worrying about renewed financial bubbles that could end badly (and it has been less than five years since the global financial crisis). The best way to lower this risk is for the real economy to gain further momentum. This would enable improving fundamentals to validate current financial asset prices, encourage companies to invest more aggressively in new plant and equipment, and increase the scope for central banks to normalize their policy approach in an orderly fashion.

MORE: At Buffett-fest, investors cautious, warming to Apple

Friday's good news confirmed that the economy continues to heal. At the margin, it reduced the risk of financial bubbles and increased somewhat the possibility of a beneficial virtual economic and financial cycle. But critical mass is yet to be attained.

So as the endogenous improvement continues, let us hope that Congress's occasionally destabilizing behavior is kept away from the economy (meaning no more disruptive debt ceiling outcomes, fiscal cliffs, and/or sequesters) and that the recent period of European financial tranquility lasts a bit longer (no more riots in peripheral economies, excessive creditor fatigue, and/or renewed dysfunction among those charged with restoring and maintaining the financial calm).

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