roach on davos

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    Global: The Hollow Confidence of Davos

    Stephen Roach (from Davos)

    The World Economic Forum in Davos always offers ample food for thought to those of us pondering the macro landscape. This year is no exception. While it’s understandably a Euro-centric crowd, all the various constituencies of globalization are well represented. The US is a notable outlier in 2005. The Bush Administration -- whose delegations in the last two years were headed by Secretary of State Colin Powell and Vice President Dick Cheney -- is almost nowhere to be seen. That didn’t sit too well with this crowd of internationalists, especially those attending the numerous sessions on American leadership.

    I find the World Economic Forum especially helpful because it deepens my understanding of the views of the global consensus that are embedded in asset markets. There were two broad areas of the debate that got my attention this year -- the first being what I would call the Davos strain of global rebalancing. The consensus at this gathering was far more sympathetic to the perils of ever-mounting global imbalances than groups I normally encounter. The notion of a newly symbiotic world -- America consumes and the rest of the world finances it -- didn’t cut it in this crowd. Concerns over ever-mounting US current account deficits, saving shortfalls, budget deficits, and household sector debt were not taken lightly. But while there was agreement on the broad outlines of the problem, there was little conviction on how these imbalances might get resolved.

    Most thought that a sharply weaker dollar held the key to the global adjustment process. I argued this perception needed to be qualified -- that dollar depreciation was a necessary but not sufficient condition for global rebalancing (see my 14 January dispatch, “The Dollar Can’t Do It Alone”). With America’s import volumes currently running more than 50% larger than exports, I view the trade gap as, first and foremost, a problem of excess domestic demand. And barring a credible program of deficit reduction from Washington -- unfortunately, an entirely reasonable assumption -- the only way to temper America’s consumption binge, in my view, is through higher real interest rates. The combination of a weaker dollar and higher real rates fits the global rebalancing script to a tee. The currency realignment changes the world’s relative price structure -- precisely what macro prescribes for a lopsided world. But the risk is it only sparks a shift in the mix between foreign and domestic production that leaves US aggregate demand largely unchanged. Only by raising real interest rates will American consumers rein in the excesses of asset-dependent demand.

    The Davos crowd pushed back on this key point. Higher real interest rates were thought to pose too much risk to rate-sensitive consumers. This would be very bad for a growth-conscious world. Most felt that America’s central bank didn’t have the stomach for this type of painful cure. In fact, the Fed was widely portrayed as likely to arrest its tightening campaign at the slightest sign of weakness in the US economy. Martin Wolf of the Financial Times argued that the question was not if the US monetary authorities should raise short-term real interest rates but whether the Fed can continue to raise rates. Fair point.

    To me, this is where the rubber meets the road on the rebalancing story. It boils down to the critical tradeoff between growth and asset bubbles. A central bank that is fearful of setting its policy rate at the appropriate equilibrium level sets up a classic moral hazard dilemma -- it convinces the investment community that the asset-dependent American consumer has become “too big to fail.” The implication is all too obvious -- a Fed that then perpetuates a regime of subnormal real interest rates. The excess liquidity that such a policy stance creates then provides a powerful incentive for investors and speculators to borrow at the short end of the yield curve and invest in longer duration assets. This, in effect, creates artificial demand for long-dated securities -- compressing yields on riskless assets and pushing the buying into riskier asset classes.

    This is precisely what’s happening today. Despite the five measured tightenings of 2004, the US Federal Reserve has only succeeded in getting the nominal federal funds rate up to the core CPI inflation rate of 2.25%. With zero short-term real interest rates, little wonder that “carry trades” have migrated into riskier assets such as high-yield and emerging-market debt, where spreads have narrowed to rock-bottom levels. Little wonder also that US house price appreciation has now entered bubble territory. The longer the Fed maintains subnormal real short-term interest rates, the greater the possibility of a profusion of asset bubbles. The central bankers at Davos thought I came from another planet. In their view, long rates may be pinned down by the so-called “credibility paradox” -- that markets have bestowed the ultimate trust in the world’s monetary authorities when it comes to policy credibility. To me that trust is built on the artificial demand for yield that a zero real short-term interest rate creates. It is a reckless trust that I fear can only end in tears. The Davos crowd barely sniffled.

    The second big issue that I picked up at the World Economic Forum came from a wide-ranging discussion of the China factor. The consensus was very tight on the view that a soft landing had been attained -- that there was little reason to worry about the dreaded hard landing. The latest spate of year-end statistical releases on the state of the Chinese economy seemed to bear that out -- a further slowing in the growth of industrial output, fixed investment, imports, and inflation. The basic point on China’s soft landing is that it really isn’t that soft after all. If the economy has “landed” with industrial output growth still cruising in the 14.4% zone, China’s impact on the rest of the world is still likely to remain very strong.
    The Davos consensus felt that conclusion spelled a sustained period of sharply higher energy and industrial materials prices. As one senior mining executive said, “We are at the beginning of a structural bull market in materials and energy like the 1950s and 1960s.” The point was made repeatedly that the mix of global demand was shifting increasingly to the energy- and materials-intensive Chinas and Indias of the world. Focused on industrialization, urbanization, and (eventually, in the case of India) infrastructure, the growth dynamic in both of these major developing economies is widely expected to remain biased toward ever-greater energy and raw materials demand. Given the shortfall of new incremental supply in the past 20 years, the Davos crowd embraced the notion that the world was re-entering an era of permanently higher commodity prices.

    My challenge to this conclusion came on the point as to whether China, India, and others in the developing world should truly be considered an autonomous source of incremental demand in the global economy. To the extent that these economies remain wedded largely to export-led growth models, they may be nothing more than a levered play on the American consumer -- the principal engine on the demand side of the global economy. Should US private consumption ever falter -- admittedly, a long-standing concern of mine -- then the so-called “natural demand” for energy and other raw materials might mysteriously vanish into thin air. The Davos consensus viewed the China factor as sustainable and real -- with lasting impacts on sharply elevated pricing in the commodity complex. In my view, until this conclusion is stress-tested by the long overdue adjustment of the American consumer, the jury is still out on this key point.

    The consensus at this year’s World Economic Forum senses something doesn’t add up in the global economy. There was concern over America’s seemingly chronic saving shortfall and its related twin deficits. There was concern over the lack of internal demand elsewhere in the world -- especially in the wealthy economies of Europe and Asia. And there were concerns over the lack of flexibility in markets, economies, and policies in many segments of the developing world -- from China to Latin America to Russia. In the end, the Davos crowd drew its greatest comfort from the passage of time -- that an unbalanced world survived yet another year without a disruptive outcome in financial markets. It was a hollow confidence, at best.

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