stephen roach in the rear-view mirror

  1. 374 Posts.
    Global: The Lessons of 2002

    Stephen Roach (New York)

    Those of us in the forecasting business often get criticized for spending
    too much time looking in the rear-view mirror. And at, at times, with good
    reason. After all, there is no guarantee that the past is a prologue to what
    lies ahead. But I still believe that it pays to take a retrospective look
    from time to time. Otherwise, mistakes are quickly forgotten, and little is
    learned as we turn the page on our tattered calendars. In that spirit, I
    present the five economic lessons of 2002.
    Not surprisingly, the perils of deflation are at the top of my list. A year
    ago, when I first started warning of the "three Ds" -- double dip and
    deflation -- I was dismissed as something of a crackpot. That was then.
    While the double-dip never quite came to pass, there were two very close
    calls over the course of 2002. But the case for deflation has gained new
    prominence. It is now the operative macro risk shaping stabilization
    policies in Japan and the United States, and my guess is that the Euro
    authorities can't be too far behind. The lesson from all this is that the
    days of an asymmetrical focus on inflation fighting are now over. Under
    certain circumstances, low inflation can, indeed, morph into deflation.
    A corollary to that lesson is the macroanalytic inference that "output gaps"
    matter. The output gap is economists' jargon for the disparity between
    aggregate supply and demand. In recessions, the gap widens due to a cyclical
    shortfall in aggregate demand; the resulting overhang of excess supply
    lowers the market-clearing price level -- a classic disinflationary outcome.
    That balance typically swings the other way in recovery, as a bounce-back in
    aggregate demand absorbs the scaled-back capacity of aggregate supply. The
    problem comes with anemic recoveries at low rates of inflation -- precisely
    the situation today. Such a sluggish growth outcome would see the inflation
    rate continuing to move lower, perhaps even breaching the "zero" threshold.
    In that context, today's deflation risks are global in scope. That's a key
    by-product of our baseline forecast of the world economy -- a 2.9% estimate
    for world GDP growth in 2003 following two years of gains averaging just
    2.1%. Not only did the 2001-02 outcome fall a cumulative 3.0 percentage
    points below the global economy's longer-term 3.6% growth trend, but our
    2003 scenario adds another 0.7 percentage point to the global output gap --
    perpetuating the deflationary tendencies of this subpar global growth cycle.
    Moreover, our first cut at 2004 -- a 3.9% increase -- is only 0.3 percentage
    point above trend, thereby barely making a dent in the outsize imbalance
    between global supply and demand. Consequently, notwithstanding the recent
    pop in commodity prices, traditional macro tells us that a persistently wide
    global output gap makes it difficult to envision the return of pricing
    leverage at any point in the foreseeable future. The risk of global
    deflation can hardly be ruled out.
    The second lesson is that post-bubble economies remain vulnerable to
    periodic setbacks for a lot longer than most believe. That's certainly been
    the lesson from Japan's last 13 years and it has also been the case in the
    United States since the equity bubble popped in March 2000. The reason: Most
    asset bubbles -- especially the big ones -- ultimately infect the real
    economy and its balance-sheet underpinnings, leading to a build-up of
    excesses that must be worked off before economic growth can return to a
    satisfactory pace. America has made some progress in purging its post-bubble
    excesses, but these efforts have been confined to the corporate sector,
    where capital spending has been slashed and balance sheets restructured. The
    purging of other key post-bubble excesses has yet to begin -- especially
    those of the American consumer, who remains out on a limb of record
    indebtedness and subpar saving.
    The persistence of post-bubble excesses is the essence of my double-dip
    fixation. Structural imbalances are the functional equivalent of "economic
    headwinds" -- forces that restrain the pace of activity from returning to
    trend on a sustainable basis. Persistently subpar growth doesn't leave the
    economy far from its "stall speed," a weakish growth outcome that all but
    eradicates the cyclical immunities that are needed to fend off the downside
    pressures of periodic shocks. In the case of the US economy, I would place
    the stall speed in the 1-2% zone. At the same time, my guesstimate is that
    the post-bubble US growth rate will hold in the 2% range for at least the
    next year, somewhat below our official estimate of 2.7%. As was the case
    over the four quarters of 2002, there will be times when growth is well
    above this subpar norm (i.e., the first and third quarters). But it is
    equally likely, in my view, to look for quarters when the growth rate falls
    below 2% (such as the second and fourth quarters of 2002). Those all too
    frequent setbacks would find the US economy back in its stall-speed range,
    leaving it exceedingly vulnerable to any one of a number of shocks. Should
    such shocks occur -- hardly a trivial consideration given the sharp recent
    run-up in energy prices -- a recessionary relapse could ensue. The lesson of
    2002, in my view, is that the double-dip watch is far from over.
    The third lesson is that saving-short economies remain especially
    vulnerable. America is in a class of its own in that regard. Its net
    national saving rate plunged to a record low of 2% in 3Q002, literally
    one-third the subpar 6% average of the 1990s and about one-fifth the 10%
    norm of the 1960s and 1970s. The net national saving rate is the most
    important measure of domestic saving: It nets out the funds needed to
    replace worn-out capital, and it includes the combined saving of
    individuals, businesses, and government units. It is a basic economic truth
    that such saving must always equal net investment -- the sustenance of any
    economy's longer-term economic growth potential. Lacking in domestic saving,
    the Unites States has had to turn increasingly to foreign savers to finance
    its ongoing growth. This has led to an unprecedented buildup of foreign
    indebtedness -- underscoring the potential for capital flight, which could
    have ominous consequences for dollar-denominated assets. The flip side of
    the resulting capital inflows is, of course, America's record
    current-account and trade deficits, the external "leakage" that often sparks
    protectionist actions. The lesson of 2002 is that these external imbalances
    are deeply rooted in America's chronic saving conundrum, an imbalance which
    may only get worse as the Federal government budget now moves deeper into
    deficit. This mismatch could well haunt us in 2003.
    Which takes us to the fourth lesson -- the perils of a lopsided global
    economy. I have droned on about this one for a long time, but I continue to
    believe that the world is far too dependent on the United States as the sole
    engine of economic growth. One number says it all: Since 1995, our estimates
    suggest that America has accounted for 64% of the cumulative increase in
    world GDP -- double its share in the global economy. The rest of the world
    is utterly lacking in autonomous sources of domestic demand. Over the same
    seven-year period, domestic demand growth in the US has averaged 3.8%; by
    contrast, gains elsewhere in the so-called advanced world have been nearly
    50% slower, having averaged only 2.0%. With growth prospects in Europe and
    Japan anemic at best, a perpetuation of this dichotomy seems likely. Therein
    lies a key aspect of the global conundrum: The stage is set for a further
    widening in the disparities of the current-account deficit nations (mainly
    the United States) and the surplus areas (Asia and Europe). These
    disparities are presently at extremes never before experienced in the
    post-World War II era. To the extent they widen further, a lopsided world
    can only become more precarious. That underscores the potential for a
    cross-border realignment of relative asset prices -- especially currencies
    but also stocks and bonds. Such imbalances are also a breeding ground for
    intensified trade frictions and geopolitical tensions. Those fears could
    well come to a head in 2003.
    I suspect that the final lesson of 2002 could well be the hot topic of 2003
    -- policy traction, or the ability of stimulus measures to work. To their
    credit, policy makers are now on board with many of the issues noted above.
    I suspect financial markets will initially take heart in the potential for
    these actions to work. That has led to my uncharacteristically bullish
    stance on world equity markets in early 2003 -- the so-called "reflation
    trade" (see my 16 December essay in Investment Perspectives). But I continue
    to have strong doubts as to whether those stimulative actions will truly
    deliver. The persistence of excesses suggests that a "structural purging"
    could well take precedence over a prompt revitalization of aggregate demand.
    That's especially the case if businesses continue to cut costs in a
    "no-pricing-leverage world," and even more so if the onus of such cost
    cutting falls on workers/consumers.
    To that end, I must confess to being highly suspicious of the sure-thing
    monetarist answer to deflation that is now in vogue in official policy
    circles. Sure, there is a lot of liquidity flowing into the system right
    now, but there are no guarantees that it won't be absorbed by the
    imperatives of balance sheet repair. Finally, I would stress yet again that
    America's most policy-sensitive sectors -- consumer durables, homebuilding,
    and capital spending -- have all gone such to excess in recent years that
    it's hard to envision the upside from here. Consequently, notwithstanding
    recent reflationary actions, there are no guarantees that policy makers
    don't end up pushing on a string, a classic pitfall of a post-bubble
    economy. In my view, a US-centric world remains vulnerable to just such a
    possibility. Investors have long been taught not to bet against the
    authorities. Those bets, however, need to take account of the perils of a
    post-bubble era. My fear is that the lack of policy traction in 2002 could
    well be a hint of what lies ahead in 2003.
    I've left a lot out in this discourse. But I can't close without straying
    from my perch and offering a market-based lesson from 2002 that seems
    particularly apt as we peer into 2003. The standard line I hear from equity
    investors these days is that we simply can't have a fourth down year in a
    row. After all, we hadn't seen three consecutive annual declines in some 60
    years. Another down year would hearken back to the rout of 1929-33, utterly
    inconceivable to most. Unfortunately, this is precisely the same logic that
    was used on the upside of the Roaring Nineties. Beginning with the unlikely
    outcome of three consecutive double-digit up years, there was doubt all the
    way up. By the time the fifth year came along, the lessons of history had
    been completely tossed aside. Now, a similar mind-set lurks on the downside.
    With all due respect to the consensus, this debate is not about numerology.
    It's about picking up the pieces from the greatest bubble in modern history.

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