Global: Watch the Aftershocks
Stephen Roach (New York)
The initial shock effects of the 11 September terrorist attacks on the US economy now appear to
be subsiding. At least that’s the message to take from the recent downtrend in new jobless claims
and an apparent bottoming in consumer confidence. This should not be surprising. Time -- and the
absence of further shocks -- is usually the great enabler of healing. And it’s no different this time.
The onset of psychological healing and its attendant economic impacts are going pretty much
according to the script we first embraced in the aftermath of this devastating blow (see my 13
September essay in Investment Perspectives, "The Macro of Tragedy and Healing"). There can
be no greater testament to the inherent resilience of the US economy.
Yet this predictable healing underscores the growing possibility of a new complacency. Just as
the psychological shocks are now subsiding, new systemic risks are being unmasked by a world
in the grips of a tough synchronous recession. Four potential aftershocks worry me the most right
now -- yen weakness, aggregate demand distortions in the United States, Euro-recession, and the
possibility of deflation. All of these developments have the potential to further destabilize an
already weakened global economy. The potential impacts of these aftershocks could be worse
than the impact of The Shock itself.
The recent slippage in the foreign exchange value of the yen is especially worrisome in that
regard. It underscores how truly desperate the state of affairs in Japan has become. With the
traditional avenues of monetary and fiscal stimulus all but exhausted, the onset of renewed
recession in the Japanese economy -- by far, the worst of its four downturns of the past decade --
has left the authorities with few options. Any progress on reforms is being offset by the
counter-weight of the business cycle. That’s especially the case on the cleanup of nonperforming
loans in the banking sector, where the downside of renewed Japanese recession is creating a new
tranche of NPLs that is on a par with Y4-5 trillion of annualized disposal set by the Financial
Services Agency (FSA).
Against that backdrop, the markets are rife with talk over the possibility of a Japan that has been
given the go-ahead by the international community to engage in competitive currency
devaluation. As reported in the 22 November Financial Times, the Bank of Japan may now be
giving serious consideration to the possibility of massive foreign bond purchases -- presumably
US Treasuries. This is consistent with the BOJ’s own admission that the purchase of
"nontraditional assets" should be viewed as an increasingly viable option for a central bank that
has already taken short-term interest rates effectively to zero. For Japan this is tantamount to
unsterilized intervention, which would drive the yen lower. Moreover, it has the added advantage
of fitting the script of increasingly concerned US authorities, who shocked the Treasury market
with their Halloween surprise of announcing the end of the 30-year government bond. If
"Operation Twist" didn’t succeed in getting US long rates down, maybe massive Japanese buying
will.
I guess I’m not conspiratorial enough to buy this yarn. While it is consistent with some of the
tactical objectives of both the US and Japan, I just don’t believe that the authorities are myopic
enough to overlook the obvious perils of such a gambit. After all, Japan’s external sector -- the
average of exports and imports -- accounts for only about 10% of its economy. That means it
would take a massive degree of yen depreciation -- probably to at least 160 versus the dollar -- to
make a real difference insofar as aggregate growth in the Japanese economy was concerned. By
contrast, a modest degree of yen depreciation would accomplish next to nothing.
But there would also be a good deal of collateral damage from another round of yen depreciation.
For one thing, it would represent a real setback to the restructuring of Corporate Japan, providing
cover for the "zombies" -- the walking dead of the Japanese business community -- at precisely
the point when they have basically no choice other than to face up to wrenching change.
Moreover, another round of yen depreciation would also be strikingly reminiscent of the script of
1996, which many believe sparked the Asian financial crisis of 1997-98. And yen depreciation
would bring the "China factor" back into play as a potential source of instability for Asia and the
broader global economy. I worry increasingly about this apparent collision course between the
two most powerful economies in the region. A few weeks ago on my last visit to Japan, I was
struck with a surprising outpouring of China bashing, with the complaint largely focused on
China’s extraordinary labor cost advantage. Ongoing Japan-China trade skirmishes only
compound the problem.
Japan could be heading down a very slippery slope. Economic history is devoid of successful
examples of competitive currency devaluation. "Beggar-thy-neighbor" policies are really the last
thing a world in synchronous recession needs. Yet as this global recession now spreads and
deepens, it pays to be mindful of just such risks.
Potential demand distortions in the US economy qualify as a second set of worrisome aftershocks
in the aftermath of 11 September. In a deteriorating cyclical climate, "zero-financing" for cars
brings forward demand -- it cannot be expected to create new demand. The same can be said for
any renewed surge in the "refi cycle," although the recent backup in longer-term interest rates --
in conjunction with shifting household preferences for saving and balance sheet repair -- may
have already inhibited the Fed’s ability to jump-start aggregate demand. In any case, to the extent
that demand is being artificially supported during a recession, the possibility of a "payback" must
be taken quite seriously -- once the life-support measures have been removed.
In that vein, I continue to worry about the a US economy that hits another air-pocket in the early
months of 2002 -- as the demand payback effect gets reinforced by the downside of flexible
compensation arising from disappointing year-end bonuses, profit sharing, and stock-option
awards. For financial markets rallying on the premise of post-shock healing and recovery, any
such air pocket could come as an especially rude awakening. For a US-dependent global
economy, it could also trigger another wave of deterioration in the global trade cycle -- the stuff
of an ever-deeper synchronous recession.
The onset of a European recession is a third aftershock that has the potential to prompt further
damage to the broader global economy. Euroland is the classic example of a slow-growth
economy that was lacking in a cyclical cushion when the shock of 11 September hit. The
two-piece recession model that I have long embraced -- "stall speed" and a shock -- would have
quickly qualified Euroland as a prime suspect for outright recession in the aftermath of the jolt
that hit America. Euroland had already been softened up earlier in the year by a US-induced
downturn in the IT-led global trade cycle. Pan-regional GDP growth had already slowed to its
stall speed before 11 September -- edging ahead at a mere 0.1% (QoQ) in the two middle quarters
of 2001. In the face of such anemic pre-shock growth -- quite comparable to the situation faced in
the United States, as well -- the terrorist attacks on America certainly seem to have been the
straw that broke the proverbial camel’s back.
The issue no longer is whether Europe slides into recession but the extent of any collateral
damage that stems from this outcome. The persistence of a chronically weak euro would be one
obvious by-product of such an outcome. That acts further to undermine confidence in EMU, to
say nothing of putting a damper on the region’s structural reforms. But the currency angle, itself,
could come back to haunt the United States. In a synchronous global recession, no major
realignments in economic fundamentals are likely to occur between the three currency blocs.
Consequently, notwithstanding America’s chronic current-account deficit, there’s good reason to
think that the dollar’s long-awaited depreciation could be deferred yet again. Moreover, to the
extent that investors believe that the US will once again lead the world back to the upside, the
greenback could well strengthen further. Needless to say, a recessionary US economy would
benefit more from currency depreciation than appreciation. Essentially any economy in recession
would. But the United States may be on the short end of that stick. In the zero-sum game of
relative currency values, America looks like the clear loser in terms of getting any support from
external demand.
That’s not to say all the aftershocks of 11 September are an unambiguous negative for a world in
recession. The downward spiral in commodity prices -- especially oil -- provides a sharp stimulus
to inflation-adjusted purchasing power. That puts a floor on consumer demand and could well
reinforce the reflationary impacts of policy stimulus, if and when they begin to kick in. Most rules
of thumb suggest that a $10 reduction in crude oil prices adds between $75 to $100 billion of
disposable income to the US economy -- the functional equivalent of nearly a 1% tax cut. There
is, however, an important flip side of this argument. The global economy entered this recession
with a very low inflation rate. The downside of this business cycle should take that inflation rate
even lower. A free-fall in oil prices could well bring the US and the world economy all the closer
to outright deflation. In a synchronous global recession, there’s less wiggle room for a
low-inflation economy than otherwise might be the case. I continue to believe that any whiff of
deflation could be a very tough blow for the global economy and world financial markets.
All this underscores one of the key principles of macro-shock analysis that we stressed from the
start: Context is key. If you had thought the world economy was in good shape on 10 September,
then the terrorist attacks on America would qualify as nothing more than a temporary blow. If, on
the other hand, you believed, as we did, that the world had already entered a mild recession
before The Attack, the aftershocks could be the defining parameters of macro risk over the next
couple of years. For me, that’s the bottom line: As risks now shift from The Shock to its
aftershocks, perils to the global economy could well intensify. To the extent a new round of
investor complacency is starting to creep in, world financial markets could be exceedingly
vulnerable.
morganstanley.com |
