How Could I Be So Stupid?...
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Morgan Stanley's Global Economic Forum
Mar 11, 2002
How Could I Be So Stupid?
- Stephen Roach / Morgan Stanley
I’ll never forget the sage advice of my first boss, the legendary Arthur
Burns, Chairman of the Federal Reserve in the 1970s. "Son," he said
through pipe-clenched teeth nearly 30 years ago, "never under-estimate
the inherent resilience of the US economy." Obviously, it’s a piece of
advice I have long since forgotten on my own personal journey. Yes, I
nailed the recession call of 2001. But I seem to have forgotten what
always comes next -- cyclical recovery. How could I be so stupid?
Forgive me, if I indulge in a bout of self-flagellation. But I have always
felt that we learn more from our mistakes than from those ever-fleeting
successes. Don’t get me wrong, I am not abandoning my call for a
double-dip recession in the United States. I still think there is a
compelling case in favor of a relapse later this year -- but obviously one
that would come later and off a higher level of economic activity than I
had thought. But the feedback is not exactly encouraging these days --
from the markets, the clients, and even the guys down the hall. I think
I am probably the last living economist in America to still embrace the
possibility of a double dip -- or for that matter even a subdued or
sluggish recovery (a.k.a. the Nike swoosh). One good thing about my
approach to economics, if I could be so bold to say, is that it is very
transparent. What you see is what you get. It’s an analytically driven
approach that rests on a set of very clear assumptions. As such, it
enables me to understand the whys of my mistakes with painful clarity.
And so I ask myself, What is it that is so flawed about my prognosis?
If my basic view of the economy turns out to be as wrong-footed as
most now suspect, I would argue that I must have five basic
assumptions dead wrong.
First, I must have missed the mark on the
character of this business cycle. I have long argued that this is a
capital-spending-led downturn that reflected the unwinding of excesses
on the supply side of the macro equation brought about by the equity
bubble. As such, I have viewed the US economy as laboring under the
weight of a series of post-bubble aftershocks brought about by low
saving, excess debt, a lingering capacity overhang, and a massive
current-account deficit. While few can dispute the facts of capital
spending leadership to the recent cyclical downturn, maybe that just
doesn’t matter as much as I had thought. After all, the inventory cycle is
alive and well -- the most salient characteristic of any business cycle.
Maybe that matters more than the unusual mix of final demand
weakness in the recent downturn.
Second, I seem to have forgotten the four most important words in
modern-day financial market history -- don’t fight the Fed. The 475 bp
of monetary easing of 2001 was staggering in both its speed and
magnitude. In the eyes of most, the resulting surge in liquidity meant it
was only a matter of time before the economy responded. It must have
been the lags I missed -- that long and variable response time between
rate cuts and the credit-sensitive sectors of the economy. I guess I was
so hung up on the excesses on the supply side -- a capacity overhang
that had to be worked off, irrespective of any level of real short-term
interest rates -- that I lost sight of how quickly monetary easing must
have fed through to the rest of the real economy.
Third, it also appears that I committed the cardinal forecasting error of
betting against the American consumer. I should have known better.
After all, Arthur Burns also warned me never to count out the American
consumer. Unfortunately, he issued that warning in the mid-1970s --
right on the brink of the worst consumer-led recession in post-World
War II history. Never mind, today’s American consumer keeps on
spending in the face of terrible macro fundamentals -- rock-bottom
saving rates, record debt loads, faltering wage income growth, mounting
layoffs, and depleted equity wealth. The ever-clever American consumer
appears to have figured out a way around any conceivable type of
adversity. Lower energy prices, modest tax cuts, and home mortgage
refinancing appear to have been more than offsetting. How could I have
missed that?
Fourth, I may have been too hard on Corporate America. Sure, the US
just went through the worst earnings recession in more than 50 years.
And the Enron debacle has raised profound questions about earnings
quality. But that’s not the end of the world for a nation that is the
champion of creative destruction. After all, ever-nimble corporate
managers have been quick to respond to economic adversity -- cutting
costs with seemingly reckless abandon. Capital spending programs have
been slashed, inventories pruned, and headcounts reduced -- at least
for the non-managerial piece of the workforce. This is quintessential
cost-cutting that paves the way for a big rebound in earnings -- and
concomitant increases in hiring and capital spending. Never mind that
the business community doesn’t exactly see it that way. Economists
always know better.
Fifth, I must have blown the global angle as well. All this stuff about
America’s massive current account deficit and an overvalued dollar just
has to be wrong. The world is more than willing to condone another
spurt of US-led global growth. After all, who else could be the world’s
growth engine? Never mind that America might have to attract close to
$2 billion of foreign capital per day in 2003 to finance its external
imbalance. The US had done it before, and it will do it again. After all,
just consider the alternatives. Europe? Japan? Not a chance on either
count. America wins hand down for a seventh year in a row. The US
needs to keep its great domestic demand machine humming. How else
can the export-led strain of growth elsewhere in the world ever get going
again? I can’t believe I was dumb enough to miss that basic point as
well.
All right, so let me tell you what I really think. Forgive me if I dare
challenge the "Big Mo" and run against the grain of the numbers and
the markets. But I still like the same old story I’ve been telling for
some time. I think the unique capital-spending-led character of this
business cycle will ultimately be decisive in shaping a very subdued
growth outcome for the US economy in the years ahead. Double dip or
not, today’s post-bubble headwinds are every bit as powerful as those
which held back the vigor of recovery for 2 1/2 years in the early 1990s.
Nor do I believe the Fed can do much to change the endgame. An
economy plagued with excess supply is far less responsive to monetary
stimulus than is an economy saddled with inadequate demand.
Moreover, since two of the economy’s most interest rate-sensitive
sectors -- consumer durables and homebuilding -- held up amazingly
well in the downturn, there’s not much upside from these classic drivers
of a Fed-induced recovery. That leaves unanswered the key question of
the recovery call: What sector will spark the rebound?
As for the American consumer, time will obviously tell. But in my book,
over-extended consumers have simply run out of rope. If we’re in a
vigorous recovery, the refi and energy price breaks will most assuredly
go the other way. And I dare say cost-conscious businesses will be
reluctant to add to add aggressively to payroll expenses -- either
through hiring or wage concessions. Sorry, but that will crimp household
purchasing power -- long the key driver of consumer demand. There’s
also a key demographic point that has long concerned me: As the
saving-short and aging American consumer now closes in on retirement,
the increased prevalence of defined-contribution retirement regimes
could well spark a lasting shift in the preference for saving. That implies
that the days of open-ended spending, without any regard for life-cycle
saving objectives, are drawing to an end.
Nor do I think the corporate turnaround will exactly come in a flash. As
Steve Galbraith continues to stress, earnings disappointments are
lingering in early 2002, even in the face of easy comparisons with a year
ago. That shouldn’t be all that surprising. Business cost structures --
both for labor and fixed capital -- were configured to match the
bubble-induced excesses of the late 1990s. While cost-cutting has been
aggressive over the past year, it has yet to reflect a corporate mindset
that has truly given up the ghost of the bubble. With the macro
numbers now spinning toward recovery, a bit of déjà vu might be all the
more tantalizing. But with the risks still skewed more toward deflation
than inflation -- another key premise of mine that the markets are now
challenging -- I am hard-pressed to believe any recovery in volume will
be vigorous enough to offset the lack of pricing power.
Finally, I remain steadfast in my belief that America’s gaping
current-account deficit is a wake-up call that a US-centric world can no
longer ignore. If left to its own devices, another few years of US-led
global growth could take America’s balance of payments deficit toward
7-8% of GDP. History is utterly devoid of examples when such a
massive external imbalance did not trigger a realignment in relative
growth rates and/or a sharp currency depreciation. I do not believe that
this time will be the sole exception. The dollar is already starting to look
heavy under the weight of the extraordinary volume of external
financing that looms ahead. I fear that’s only the beginning.
I guess what it all boils down to is that I’m still as dumb as ever. Arthur
Burns would have never forgiven me.
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