The latest views of Morgan Stanley Economists
October 01, 2001
Stephen Roach (New York)
The debate has shifted from recession to recovery. In the aftermath of the terrorist attacks of 11 September, our once out-of-consensus recession call has now become conventional wisdom in the financial markets, as well as in business and policy circles. There is some disagreement over the depth and duration of this recession, but those issues have now been relegated to detail status. The character of the coming economic recovery -- especially the norms that lie beyond the cycle -- is what the debate is all about.
Prior to The Shock, I was firmly in the L-shaped camp. I had favored a scenario that I dubbed an "American-style ‘L,’" which envisioned the US economy holding to a 1.5% to 2.0% growth path over the 2001-03 interval (see my 7 May essay in Investment Perspectives, "An American-Style ‘L’"). As the likelihood of a deeper recession increased in the past few weeks, my timeworn instincts as a business cycle forecaster took over. Deep recessions typically trigger the cyclical manifestations of vigorous snapbacks -- inventory liquidation, pent-up demand, and reflationary policies. Inasmuch as I see no reason to believe that this time will be much different on those counts, my initial instincts were to give a higher probability to more of a V-shaped cyclical recovery than I was looking for before The Shock (see my 13 September essay, "The Macro of Tragedy and Healing"). Dick Berner’s revised forecast for the US economy is broadly consistent with that same conclusion -- a GDP growth rate of close to 5% in the second half of 2002. Needless to say, to the extent momentum-driven investors would extrapolate into the future on the basis of such an outcome, there would be great cause for celebration.
Like recessions, however, recoveries are largely transitory events. And this one could be more transitory than most. Once the cyclical forces run their course, the economy then reverts back to its underlying, or steady-state, norms -- what economists call potential GDP growth. The key is to figure out what that norm will be. This is the issue that I now believe will become central to the debate in financial markets, Washington, business circles, and Main Street. As I see it, most are still clinging to the notion that The Shock is a cyclical event that will be quickly be followed by a reversion back to the growth norms we had all gotten accustomed to in the latter half of the 1990s. Our client polling tells us that, as does the work of our quantitative analytical group, when they attempt to discern "what’s in the market." By contrast, I believe that the United States is at a key secular juncture, with the growth norms of the next five years likely to fall well short of those of recent years.
There are four building blocks to this conclusion -- the first being a likely erosion of the productivity underpinnings of the US economy. This, of course, was the cherished foundation of the once glorious New Economy. The consensus truly believed a powerful new productivity trend had emerged by the end of the 1990s, somewhere in the 3% vicinity. If correct, that would have represented a stunning improvement from the anemic trend of 1.25% that was evident from the early 1970s to the mid-1990s. The boom, itself, seemed to validate this optimistic scenario. Productivity growth averaged 3.5% from mid-1998 to mid-2000 -- providing what many believed was the "silver bullet" for America’s New Economy renaissance. (Note: Reflecting the government’s annual reworking of the national data, this two-year growth rate was recently revised down to 3.1%; however, consensus perceptions were formed largely on the basis of pre-revision statistics.)
My own view is that a significant downshift in trend productivity is now likely. I wouldn’t be surprised to see gains over the next five years average only around 1.25% to 1.75% -- possibly less than half those realized during the latter half of the 1990s. Three reasons support this conclusion: First, the cyclical impacts of "capital deepening" are now swinging the other way. To the extent that much of the productivity surge simply reflected an unsustainable IT buying binge, an elimination of that excess capacity will now depress productivity. Second, the cost of doing business -- both for Washington as well as for Corporate America -- has permanently changed. Shipping costs, building security, insurance premiums will all be higher. Moreover, as Dick Berner has argued, Washington will now begin to spend the peace dividend on a defense and homeland security effort. All this means an increasingly larger slice of national output will now have to be directed toward non-productive activities. Third, America’s IT network -- the glue of the new productivity paradigm -- is not the secure, low-cost platform of connectivity we thought it was. A new e-based terrorism, underscored by the lethal Nimda virus, is still wreaking havoc on many large networks. This not only tells us how fragile the IT infrastructure is, but it also hints at the need for a huge fix to network security. Such a time-intensive and costly endeavor is the functional equivalent of a tax on the corporate IT infrastructure -- yet another impediment to trend productivity growth.
A second building block to the case for subpar growth norms is the legacy of America’s structural excesses of the late 1990s. This was the essence of my original case for the American-style L, and I don’t believe The Shock changes the point much at all. Courtesy of the bubble, the US economy was left with a serious array of structural imbalances -- a massive current-account deficit, a huge capacity overhang, a record shortfall of personal saving, and a worrisome buildup of household debt. Slow growth is the antidote for these excesses, which were largely brought about by an American economy that has long been living well beyond its means. A deeper recession could accelerate a purging of the excesses but it would not alter the endgame -- especially if it is followed by more of a V-shaped snapback in the early stages of recovery. Reflecting the excesses that emerged in the late 1990s, the United States, in my view, will be facing powerful structural headwinds for years to come. That will also put a lid on the economy’s potential growth rate.
Third, is a likely retreat from globalization. I have detailed my thoughts on that elsewhere, but my basic point is that the world economy could well pay an important and lasting price for terrorist attacks of 11 September (see my dispatches of 21 September "Globalization at Risk" and 26 September, "Globalization’s Haunting Past"). The glue of globalization -- trade and financial capital flows, globalized supply chains, and rapid expansion of trans-national flows of multinational corporations -- suddenly seems less binding. There is new sand in the gears of what was thought to have been increasingly frictionless cross-border linkages. Increased expenses for border security, shipping, and insurance, are, in effect, a new tax on cross-border connectivity. Moreover, the lingering fear of the next event -- terrorist attack or retaliation -- will increase the risk premia placed on such linkages. At the margin, all this raises the price of the outward-looking flows that drive globalization. Nor would this be the first time that globalization sowed the seeds of its own demise. That’s exactly what happened in the early 1900s and again in the 1920s. I believe that the impacts of globalization may have boosted trend growth in the US by anywhere from 0.5% to 1.0% annually in the latter half of the 1990s. The positive impacts on corporate earnings and equity prices were unmistakable. With globalization at risk, these impacts are now likely to swing the other way.
Fourth is a softer point but one I believe could be equally important in shaping America’s new growth norms. In my opinion, the psyche of private sector decision-making has been dealt a lasting blow by the events of 11 September. Like grief, time will heal. But I suspect the healing will leave the mindset in a very different place. Matters of personal, corporate, and national security can no longer be taken for granted. That will cast a lasting pall on the values that shape risk-taking strategies -- for consumers and businesses alike. Increasingly risk-averse investors may be more satisfied to realize moderate, but safe, returns in a less secure world. In economic terms, this could well reduce the preference for leverage and tilt the balance away from the excesses of spending and back toward a long needed rebuilding of saving. The demographics of an aging population have long been pointing in that direction, and The Shock could represent a real wake-up call for saving-short Americans. A similar jolt might effect the risk-taking mindset of entrepreneurs and venture capitalists. Defining moments are all that -- and more.
There are many that want to frame the debate in black and white, asking if The Shock represents either a cyclical or a secular turning point. I worry this "either-or" framework oversimplifies the story. To me, it’s both -- a cyclical event with profound secular implications. Business cycles are always a temporary deviation from norms. In that respect, this one is no different. But there is an important twist to what now lies beyond the cycle. When the vigor of any recovery subsides, I believe that America will converge on a new set of norms that is very different from those, which we had become accustomed to. And I suspect those norms will constrain the US economy to a much slower growth potential than we had previously thought.
It’s not easy to quantify the new norms that lie ahead. It never is. But I think there are compelling reasons to believe they will be well below those of the roaring nineties. Over the mid-1996 to mid-2000 interval, trend GDP growth in the US economy was 4%. Looking ahead over the next five years, my guesstimate would be for a downshift back into the 2.5% range -- only a slight improvement from the pre-bubble norms of the early 1990s. Like the NASDAQ bubble, I suspect that history will judge the performance of the US economy in the latter half of the 1990s to have been an aberration, not the dawn of a New Era. The Shock is a wake-up call for those still clinging to now-antiquated perceptions of America’s growth dynamic. Call it the end of the New Economy. That suggests a significant re-rating of asset prices still lies ahead.
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