Global: Last Line of Defense
By Stephen Roach
Chief Economist and
Director of Global
Economic Analysis
Morgan Stanley
Jul 26, 2002
In the end, it probably all boils down to the American consumer. Long the bedrock of the US economy -- accounting for two-thirds of America’s GDP -- the US consumer has also become the world’s consumer of last resort. In my view, the excesses of the American consumer will go down in history as one of the hallmarks of the 1990s. Before sustainable recoveries can be established in the US and the broader global economy, I maintain those excesses must be purged. There is good reason to believe that just such a purging may now be close at hand.
The macro model of consumer behavior is relatively straightforward: Personal consumption is driven by the combination of income and wealth effects. While empirical evidence suggests income effects outweigh wealth effects by a factor of nearly ten to one, consumers were not exactly bashful about drawing incremental support from asset appreciation during the greatest financial bubble of them all. Initially, consumers spent equity wealth effects and, more recently, they have been tapping the home equity till. Financial conditions also matter, but mainly in defining the context for consumption adjustments. On that basis, the confluence of a low saving rate, record debt loads, an aging demographic profile, and an increased incidence of defined-contribution pension plans all speak of unrelenting structural pressures bearing down on the consumption outlook.
Against that backdrop, the American consumer is about to be caught in a vice. At work, in my view, will be the combined impacts of three powerful macro forces that take dead aim on US consumers -- wealth destruction, a long overdue US current-account adjustment, and the coup de grace -- a negative income shock. With all of these forces aligned against the heretofore-resilient consumer, I believe the last line of defense against the double dip will finally be breached.
In recent months, I have droned on ad nauseam about these macro pressures. A brief summary should suffice at this point. The wealth effect has now become a household term. The carnage in the stock market speaks for itself: The major indexes are back to mid-1997 levels before adjusting for 12 percentage points of inflation over that five-year period; moreover, the annual return of the average fund investor was just 5.3% over the 1984-2000 interval, only about one-third the 16.3% annualized return of the S&P 500 over that same time frame. By contrast, residential property values have held up a good deal better, enabling consumers to shift their equity-extraction tactics to real estate. But there is good reason to believe that the property cycle is about to turn, as well. Courtesy of stronger-than-expected housing starts over the past couple of years, a supply overhang could well be in the offing -- especially if the demand side weakens in an income-constrained climate, as I suspect. If that turns out to be correct, the American consumer would make an undeniable transition from being wealth-supported to wealth-constrained.
A US current-account adjustment should also put extreme pressure on the American consumer. The current-account deficit reflects the unmistakable symptoms of a US economy that has long been living beyond its means -- as those means are defined by the economy’s domestic income generating capacity. Key in that regard are the excesses of personal consumption growth. Over the four-year period from 1997 to 2000, real consumption growth averaged 4.6% -- fully one percentage point faster than the 3.6% average gains in real disposable personal income over that same period. With goods imports rising to a record 35% of GDP by the end of the 1990s, this excess consumption growth was the principal force behind the import-led deterioration in America’s foreign trade and current-account balances. In my opinion, the coming current-account adjustment cannot occur without a significant compression in consumer demand -- and the concomitant compression in imports that such an outcome would engender. And that’s exactly what appears to be in the cards.
An income shock, if it occurs, would be the clincher. As always, income and employment trends go hand in hand. The case for an income shock rests on the likelihood of another wave of layoffs triggered by intensified corporate cost cutting. Still margin-constrained -- despite the arithmetic rebound now under way -- and lacking in pricing leverage, stock-market-battered US businesses can hardly afford to breathe easy on the earnings front. The likelihood of heightened accounting disclosures stemming from businesses’ reaction to America’s corporate governance shock will only magnify that response, in my view. As a result, cost cutting should intensify as companies finally face up to the seemingly chronic conditions of bloated cost structures and excess capacity. With labor compensation accounting for 70% of total business expenses, another round of headcount reductions is increasingly possible, in my view. That seems especially likely in the high-paid managerial ranks, where staffing has gone to excess in recent years. This is strikingly reminiscent of the early 1990s, when a mid-managerial shakeout kept the national unemployment rate rising for fully 15 months into the then nascent recovery. A decade later, another managerial shakeout now seems to be in the offing -- conjuring up the possibility of a replay of the "jobless recovery" of the early 1990s and the subpar growth in income generation and personal consumption it fostered.
This is where politics and economics intersect. The body politic -- both at home and abroad -- can be counted on to resist strongly any efforts to lower the US standard of living. Yet to the extent that slower consumption growth may well be an unavoidable by-product of the powerful confluence of macro forces now bearing down on the US economy -- wealth destruction, a current-account adjustment, and an income shock -- I sense there is really no other option. Something has to give, and my bet is that it will be the politically expedient denial of the unstoppable American consumer.
In reaching this conclusion, I am quite mindful of the domestic and geopolitical ramifications of such a development. Just as Washington resisted Alan Greenspan’s initial efforts to pop the equity bubble in early 1997, it can be expected to launch a similar outcry if the American consumer bears the brunt of the coming current-account adjustment. At the same time, the rest of the world could well face a comparable political backlash. I worry most about Asia in that regard -- the region of the world that remains most dependent on US-led external demand. With domestic demand still deficient in most Asian economies -- Korea has been the sole exception -- a capitulation of the American consumer could well take the region back to the brink of recession. For countries that were in unprecedented crisis a mere three to four years ago, another economic shock could be profoundly destabilizing to the entrenched political power structure.
China strikes me as also vulnerable in this context. Lacking a domestic consumer culture, China remains very much dependent on exports to the United States to keep its growth miracle alive. In fact, Chinese exports to America surged at a 19% annual rate in the first half of this year. If this source of external support were to dry up, the resulting shortfall in Chinese economic growth could well have profound political implications. Either reforms would have to slow or social stability would come under pressure by the rising joblessness associated with the restructuring of state-owned enterprises. Needless to say, both outcomes would be tough for China to swallow.
In their spare time, consumers are also voters. And that’s where this tale could take an even stranger twist. With politicians feeling the heat from increasingly beleaguered consumers, reflationary pressures on the authorities can only intensify. In response to that political heat, US policy makers may well conclude that the American consumer is simply "too big to fail" -- setting up yet another in a seemingly unending string of moral hazards. Particularly disconcerting in that regard were Federal Reserve Chairman Alan Greenspan’s recent admission that he would be delighted if American households continue to spend newly extracted equity from rapidly appreciating property values.
In the end, of course, there is no easy way out. Asset-based consumption growth -- and the excess leverage it spawns -- sets any economy up for systemic risks and a serious shakeout. That’s especially the case if asset appreciation morphs into a bubble. And I guess that’s precisely the point: In my view, the combination of post-bubble repercussions and a current-account adjustment seals the fate of the over-extended American consumer. I suspect that the body politic -- in the US and around the world -- will do everything in its power to buttress America’s last line of defense. That’s where this story could get even more interesting.
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