printed copy of Roach (on the markets)
I print it out because in a couple days, that link will not produce Roach's editorial
here it is /jw
Stephen Roach (New York)
Courtesy of yet another wrenching downdraft in US equity markets, America’s wealth-dependent culture is facing a stern challenge. The virtuous circle of the 1990s is on the brink of morphing into a vicious circle. This is the twilight zone of asymmetrical risks, when the system’s response to the fear of bad outcomes starts to take on a life of its own.
It all started with the bubble, of course -- the transforming macro event of our generation. The problem with bubbles, to paraphrase a now classic musing of Fed Chairman Alan Greenspan, is that you never know you’re in one until it’s long since popped. (The exact citation from his infamous December 5, 1996 speech: "How do we know when irrational exuberance has unduly escalated asset values…?"). I guess, by now, we all know what we’ve been through. If the 73% decline of Nasdaq from its March 2000 peak doesn’t validate the notion of a bubble, it’s hard to know what would. But the real problem with popped asset bubbles is not the first-round impacts of wealth destruction. It’s the collateral damage that alters risk assessments in financial markets and the real economy. Now, fully 28 months after Nasdaq crested at 5000, those are the very repercussions that threaten to reshape much of what we have come to take for granted about the US economy.
The American consumer remains at the top of my worry list in this post-bubble era. The reason -- the perils of what I have called the "asymmetrical wealth effect." This rests on the basic precepts of behavioral finance set forth over 30 years ago by Amos Tversky, a renowned Stanford University psychologist. Through experimental sampling of investor responses to hypothetical and actual financial market situations, Tversky found that the loss aversion motive of individual investors made them far more sensitive to reductions in wealth than to increases in their portfolios. The caveat came in what Tversky called "prospect theory" -- that investor responses are also influenced by recent performance. Individuals that only lose "house money" are less inclined to alter their fundamental economic behavior. Conversely, once the accumulation of losses taps into original investor principal, it’s a different matter altogether.
That, I’m afraid, is where we now stand in this post-bubble climate. All the major equity market indexes -- Nasdaq, the S&P 500, and the broader Wilshire 5000 -- have made round trips back to levels prevailing back in mid-1997. Over that same five-year period, the Consumer Price Index has risen a cumulative total of about 12%. In other words, five years of unchanged nominal equity portfolios translates into a loss of about 12% in real, or inflation-adjusted, terms. Of course, that’s even more of a setback when compared with historical real returns on US stocks that have averaged about 7% per annum since 1800. That puts the underperformance of the past five years about 50 percentage points short of the longer-term norm. In the parlance of Tversky’s prospect theory, the suffering of individual investors has gone far beyond the paper losses of house money. American households are now hurting big time.
Alas, there’s far more to individual investor pain than five years of paper losses. Saving short and overly indebted, the aging American consumer is also closer to retirement, on average, than at any point in the post-World War II era. Moreover, with pension fund regimes having shifted increasingly from defined benefit to defined contribution schemes -- assets in DC plans first exceeded those of DB plans back in 1997 -- the nest egg now looks more precarious than ever. In addition, the equity culture has become more essential than ever to American households in achieving their life-cycle saving objectives. As President Bush indicated in his 9 July speech on corporate responsibility, more than 80 million Americans now own stocks -- either directly, in mutual funds, or through their pension plans. It is in this broader context that I believe that five years of real wealth destruction have the clear potential to trigger the powerful loss aversion responses first envisioned by Amos Tversky. Given the demographic profile of an aging American population, saving imperatives are all the more important. That means American consumers now need to save the old-fashioned way -- out of their paychecks. As I see it, the increased likelihood of a shifting preference toward saving could well be the essence of the coming asymmetrical wealth effect.
An analogous asymmetry seems likely in the policy arena. The post-bubble perils of the debt-deflation cycle are the ultimate nightmare for monetary and fiscal authorities. Just ask Japan -- or, for that matter, the United States in the 1930s. Policy makers cannot afford to take these risks lightly in the aftermath of a popped asset bubble. That verdict comes through loud and clear from a recent joint research effort just published by some 13 economists on the staff of the Federal Reserve Board (see "Preventing Deflation: Lessons from Japan’s Experience in the 1990s," International Finance Discussion Paper No. 729, June 2002). The Fed paper makes it quite clear that just the risk of deflation in a nation’s aggregate price level should be sufficient to trigger aggressive reflationary policies. The popping of a major asset bubble at low levels of GDP-based inflation -- precisely the case in the United States -- only serves to underscore those very risks.
For that reason alone, the conclusions of this Fed research paper seem quite relevant to me in assessing the prospective stance of the US monetary authorities. The Fed staff argues that the Japanese authorities should have been more aggressive in pursuing monetary easing and fiscal stimulus. In effect, they waited until it was too late. In large part because of that delay, the Fed researchers also found that the effectiveness of Japanese stabilization policies was diminished in the post-bubble climate -- with the authorities basically "pushing on a string" as Japan became mired in a liquidity trap. Under those conditions, the Fed staff concluded, the risk of a policy blunder that might otherwise seem to be overly stimulative need not be taken seriously. It can always be corrected once the deflationary alert ends.
We tend to cavalierly believe that America is not Japan. And, of course, in many critical respects the comparisons are wide of the mark -- especially when a functional US banking system is compared with its dysfunctional counterpart in Japan. But the Fed paper argues persuasively, in my view, that just as it was the case in Japan, it’s not worth taking deflationary risks in a post-bubble US economy. This speaks of a Fed that will remain predisposed toward monetary accommodation for some time to come. Moreover, in the event of a financial accident -- the rule not the exception in post-bubble economies replete with systemic risk -- the ever-present asymmetrical risks of a post-bubble climate underscore the distinct possibility of a monetary easing.
Finally, there’s a host of asymmetrical political risks to contend with in this post-bubble climate. The regulatory backlash against America’s corporate governance shock is the most obvious case in point. Washington seems to have gone past the point of no return in attempting to fix certain aspects of this problem. Legislation seems likely on accounting reform, at a minimum, and the issues of executive "cash-outs" and the expensing of options by corporations are very much on the table. US businesses still have the choice of attempting to forestall the legislative remedy by offering up an agenda of self-regulatory cures. So far, however, the US Congress seems to have the upper hand in the shaping the political intervention of this post-bubble era. But no matter where the fix comes from -- Washington or Corporate America -- the risks are now skewed toward re-regulation of some sort. And that, in and of itself, represents a stunning about-face from the deregulatory thrust of the past 20 years.
Virtuous and vicious circles both have one thing in common -- a tendency toward asymmetric risks. During the late 1990s, the risks were skewed decidedly toward the bullish side, as financial markets rose to ever-higher highs. In a post-bubble climate, that movie now runs in reverse. The perils of deflation are key in shaping the asymmetrical risks of consumers, policy makers, and the body politic. To the extent we treat this latest sell-off in financial markets as yet another dip-buying opportunity out of the script of the 1990s, we’re missing the basic point. In a post-bubble climate, there’s a very different set of risks to contend with. In my view, the old rules just don’t work any more.
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