roach on the us economy

The piece below by Morgan Stanley's Stephen Roach (New York)

Washington is coming to the rescue of a deflation-prone US economy. Or at
least it is attempting to do so. The Federal Reserve has led the way, and
now the fiscal authorities are joining in. While Republicans and Democrats
differ on tactics, they agree on the general dosage of fiscal stimulus over
the next year -- about $100 billion, or 1% of gross domestic product. I
applaud this rare bipartisan consensus.

Yet, if anything, a short-term stimulus of this magnitude might actually be
too little. That's because the United States is close to the brink of
outright deflation. For the economy as a whole, GDP-based inflation slowed
to just +0.8% in 3Q02, the lowest rate in nearly half a century. Another
year of subpar economic growth in the 2% vicinity -- pretty much my personal
prognosis -- could well find inflation moving even lower, possibly flirting
with the "zero" threshold of outright deflation. The authorities must do
everything in their power to avoid such an outcome.

And so Washington has sprung into action. The Federal Reserve has taken the
federal funds rate down by an astonishing 525 basis points since early 2001.
At 1.25%, this benchmark policy interest rate stands at its lowest level in
over 41 years. The Congress and the Bush Administration are now following
suit. America certainly needs that. The textbook response to the threat of
deflation suggests that all forms of stabilization policy -- fiscal as well
as monetary -- be aggressive in attempting to boost aggregate demand. At
exceedingly low rates of inflation, the risk-reward calculus urges policy
makers to err on the side of excessive stimulus. Such "over-stimulus" can
always be corrected -- if and when the economy is on the mend and
deflationary perils ebb.

But the US economy also faces profound longer-term challenges. At the top of
that list is a seemingly chronic shortage of saving -- the driver of capital
formation and the sustenance of any economy's longer-term growth potential.
America's so-called net national saving rate -- the sum of personal,
business, and government saving after depreciation is deducted -- plunged to
a record low of 1.6% of GDP in 3Q02. Not only is that less than one-third
the subpar 6% average of the 1990s but it is only about one-sixth the 10%
norm of the 1960s and 1970s. This is the domestically generated saving that
is left over to fund the expansion of America's capital stock. And now
there's less of it available for that purpose than ever before.

Moreover, ever-widening Federal budget deficits run the risk of a further
plunge in national saving. That trend was already evident long before the
latest fiscal stimulus proposals. In the first quarter of 2000, the budget
was actually in surplus to the tune of 2.3% of GDP and the net national
saving rate stood at 6.4%. By the third quarter of 2002, the Federal budget
had swung into a 1.8% deficit, and the national saving rate plunged to 1.6%.
The deterioration in the government's fiscal balance accounted for fully 85%
of the depletion in overall national saving since early 2000. Needless to
say, without compensating upward adjustments in private-sector saving -- the
opposite of what today's consumption-oriented policy makers are seeking -- a
steady stream of budget deficits could well push the already depleted
national saving rate even lower.

That would be a most unfortunate turn of events. To the extent that
America's growth imperatives cannot be financed by domestic saving, foreign
investors must provide alternative funding. The US can get that capital only
by purchasing goods from overseas, the root cause of its massive trade
deficits. Yet in the end, this is a fool's game. America is currently
running a record balance of payments deficit amounting to 5% of its GDP.
Rising budget deficits that lead to a further reduction of national saving
will take the external financing gap up to at least 6%, requiring the US to
attract about $2.5 billion of foreign capital each and every business day in
2003.

That's a most precarious foundation for the world's growth engine.
Ever-widening Federal budget deficits not only put a strain on the ability
of the United States to finance its growth-enhancing investment in plant and
equipment, but they also leave America increasingly dependent on foreign
lenders to close the financing gap. Currently, overseas investors own more
than 18% of the total market value of long-term US securities and fully 42%
of outstanding Treasuries -- dramatic increases from the shares of
mid-1990s. Such financing arrangements are tenuous at best. There's no
guarantee that foreign investors won't demand a price concession on
dollar-denominated assets to keep the inflows going. As a consequence, a
saving-short US simply may not be able to afford another era of fiscal
profligacy without suffering the consequences of a sharply weaker dollar
and/or a marked correction in other asset prices. Longer-term fiscal
stimulus plans -- such as the one proposed by the Bush Administration --
need to be mindful of this critically complicating factor.

At the same time, tax reform proposals -- however laudable -- need to be
judged against the yardstick of national saving objectives. That's not to
say that America doesn't need tax reform. The elimination of the double
taxation on dividends is one such reform that is long overdue. Such relief
has, in fact, long been at the top of my reform wish-list -- especially the
strain that would direct relief at the corporate sector. But that begs the
more basic question as to whether a saving-short nation can afford a reform
that entails a 10-year revenue loss estimated by the Bush Administration to
be in excess of $360 billion. Moreover, the wisdom of using dividend tax
cuts as a vehicle to provide short-term stimulus can be drawn into serious
question. There are certainly other less circuitous options -- such as the
payroll tax reductions the Democrats eschew -- that put more high-octane
fuel directly in the hands of consumers.

Perhaps the most troubling aspect of the "Washington fix" is the temptation
to go back to the same recipe that got America in trouble in the first place
-- hyping the stock market and the bubble-induced excesses it prompted in
the real economy. Both the Fed and the fiscal authorities seem more than
willing to embrace stock-market targeting as a means to jump-start a sagging
US economy. Fed officials have been quite explicit about the need to spark a
revival in sentiment that could well lead to another rally in the equity
market. The Bush Administration has been equally adamant over using dividend
tax relief as a means to push up share prices, spur wealth creation, and
boost the consumption of wealth-dependent investors. And the Democrats' plan
urges stimulus to business capital spending -- the last thing that a
deflation-prone economy awash in excess capacity needs. Sadly, this is a
movie we've all been to before.

America's policy challenge is daunting, to say the least. But in the end,
the authorities must not lose sight of what stirred them into action -- the
perils of deflation. For that reason alone, America needs a sizable
short-term stimulus. But a saving-short US economy cannot afford the luxury
of multi-year tax cuts and outsize revenue losses associated with long
overdue and well-intended reforms. Moreover, Washington must heed the
lessons of the Roaring Nineties and avoid the bubble-induced pitfalls of
stock-market targeting and excess capacity. Politics and economics often
work at cross-purposes. America can ill afford such an outcome today