August 05, 2002 -Morgan Stanley - Global Economic Forum
Global: The Post-Bubble Business Cycle
Stephen Roach (New York)
Last week was a defining moment for the US business cycle, in my view. Two revelations jumped off the page: First, a post-bubble US economy has turned out to be far more recession-prone than we had previously been led to believe. Second, like Japan, recovery in the post-bubble US economy is turning out to be fragile, at best; America is now back on the brink of a recessionary relapse -- the so-called double dip. Courtesy of the bubble -- both in the financial markets and the real economy -- there’s never been a business cycle like this in the annals of the modern-day experience of the US economy. It is critical to view the outlook through a new and different lens (see my 12 July dispatch, "A Different Lens").
As a perma-bull on the Chinese economy, I often get criticized for relying on China’s oft-maligned GDP statistics. Yet I am now painfully reminded of an old adage: "Those who live in glass houses shouldn’t throw stones." America’s GDP revisions in the summer of 2002 -- to say nothing of the reworking of US corporate accounting results -- make the Chinese GDP statistics look pristine by comparison. In my some 30 years of experience as an aficionado of the US business cycle, I can remember only one other instance when a statistical revision to the US numbers carried such weight. It was back in 1974, when an annual benchmark revision of the US Department of Commerce belatedly uncovered a massive inventory overhang -- the smoking gun of what turned out to be the deepest recession of the postwar era. My boss at the time -- Fed Chairman Arthur Burns -- was the greatest living expert on the US business cycle. I remember full well his reaction at the revisionist revelation. "If I had only known," he said. Of course, he knew all along -- but that’s a different story altogether.
That lesson rings true today. Steeped in denial, few have wanted to face up to how different today’s business cycle is. That’s especially true in Washington. The pre-revision data led politicians and policy makers, alike, to raise doubts as to whether the United States had experienced any type of a recession in 2001. That’s especially true of US Treasury Secretary Paul O’Neill -- the Bush administration’s chief economic spokesman. The politically correct spin coming out of Washington always ends up with the vacuous claim that the "fundamentals of the US economy have never been sounder." Sadly, in a post-bubble era -- replete with excess capacity, low national saving, a huge overhang of debt, and a massive current-account deficit -- nothing could be further from the truth, in my opinion. America’s productivity miracle is the most oft-cited counter to this litany. Yet, don’t kid yourself -- not only do we do a terrible job of measuring productivity but watch out for the coming downward revision of this metric as well (due out Friday, 9 August).
Don’t get me wrong -- this is not a "victory lap." I’ve been doing macro for all too long to believe that any one can ever nail a call. Sure, as a card-carrying double-dipper, there is some satisfaction in this recasting of recent US economic history. My guess is that such an event could actually be unfolding at this very moment. This summer’s collapse in confidence, manufacturing activity, and job creation -- to say nothing of faltering signs on the capital spending front -- are highly cyclical signs that have "dip" written all over them. Whether that gets validated in the GDP statistics -- now or in a subsequent revision -- is anyone’s guess. But there’s more to this tale than the best metric our friendly statisticians can come up with. At work could well be a new and lethal strain of economic angst that could well be with us for years to come -- America’s first post-bubble business cycle since the 1930s.
The revised numbers speak for themselves. Over the first three quarters of 2001 -- the new designation of our current recessionary period -- business capital spending is now estimated to have declined by $88.2 billion in inflation-adjusted, or real, terms. That amounts to fully 154% of the $57.2 billion decline in real GDP over the same three-quarter interval. That’s right, this recession can be more than accounted for by a collapse in business capital spending. That’s exactly what happens to post-bubble economies. Speculative excesses in asset markets distort decision-making on the supply side of the real economy. The Internet mania of the late 1990s culminated in an indiscriminate binge of spending on information technology. Corporate America became convinced that IT prowess was a sure-fire recipe for a Nasdaq-like re-rating. When the equity bubble popped, the IT bubble was quick to follow. A sharp contraction of IT spending accounted for 69% of the decline in business capital spending over the first three quarter of 2001 -- fully 106% of the decline in overall GDP during that same period. If that’s not a post-bubble recession, I don’t know what is.
Unfortunately, there’s more to America’s post-bubble shakeout than just a wrenching adjustment in IT spending. Air has been leaking out of the dollar bubble in the past few months, and I feel there is a good deal more to come on that count. But my biggest concerns are for the bubbles that have yet to pop -- personal consumption and the property markets. Over the three-quarter recession interval, 1Q01 to 3Q01, expenditures on consumer durables and residential construction collectively boosted annualized real GDP growth by 0.7 percentage points. By contrast, in the 28 quarters of the past six recessions, these same sectors lowered GDP growth by 1.2 percentage points. In other words, the sectors that normally knock the US economy into recession have done precisely the opposite this time. By the way, these same two sectors -- consumer durables and homebuilding -- normally power the conventional business cycle to the upside. That’s because when they weaken, a condition of "pent-up demand" is created -- the cars that are not bought and the homes that aren’t built. That pent-up demand then gets unleashed -- once the cycle turns. In today’s post-bubble climate, there is no pent-up demand -- it has been spent. July’s vigorous auto sales are a case in point. As I see it, the popping of consumer and property bubbles still lies ahead as potential milestones in America’s post-bubble shakeout. That tells me this saga might not end with just a mere double dip. As was the case during the triple dips of the mid-1970s and early 1980s -- to say nothing of Japan’s decade of dips -- there could well be more dips to come in America’s post-bubble shakeout.
That underscores the biggest risk of all -- the deflationary perils of a post-bubble economy. As I see it, this stands to be the next big issue shaping the macro debate. The problem is compounded by what can be called a vulnerable "starting point." The US began this recession at an exceedingly low inflation rate -- a 2.3% increase in the GDP chain-weighted price index in the four quarters prior to the cyclical peak in 1Q01. By contrast, that’s less that half the 5.1% inflation rate that prevailed, on average, at the onset of the prior six recessions. Recessions are inherently deflationary events. Six quarters after the business cycle peak in the preceding six cycles, inflation receded, on average, by 0.7 percentage point. This recession has been far more deflationary. As of 2Q02 -- fully six quarters after the latest business cycle peak -- the GDP-based inflation y-o-y rate stood at 1.0%; that’s a 1.3 percentage point deceleration from the inflation rate prevailing at the cyclical peak -- about double the disinflationary results of past business cycles. That shouldn’t be so surprising. Supply overhangs in a post-bubble economy invariably sow the seeds for a much more powerful deflationary outcome. Inasmuch as this bubble popped when the US economy was closer to price stability, deflationary perils are all the more acute.
In this case, the devil may already be in the detail. Breaking down the GDP by type of product reveals that deflation has already emerged in goods and structures but remains absent in services. That’s right, on a year-over-year basis as of 2Q02, prices were actually down 0.7% in the goods portion of the GDP and off 0.9% for structures -- product groupings that collectively account for 48% of real GDP. Only in services -- where price measurement can often be sheer fantasy (i.e., the service derived from homeownership) -- was inflation holding at a positive 2.3% annual rate in 2Q02. In other words, deflation has already reared its ugly head in a very large portion of the US economy. This mirrors the painfully classic results of a post-bubble economy. Popped asset bubbles are the stuff of an enduring price destruction.
This is obviously a tough message. And there’s a part of me that truly wishes it was wrong. We’ve all been taught that business cycle downturns clear the decks for the coming recovery, the next bull market. Now that we finally know America has had a real recession, most are leaning in that direction. Not me. This business cycle has little in common with those of the recent past. Unfortunately, it does have a lot in common with the pre-World War II boom-bust cycles triggered by speculative bubbles in financial markets. History tells us that the 19 peacetime cycles from 1854 to 1945 had recessions with an average duration of 21 months -- essentially double the 11-month duration of post-1945 recessions. Post-bubble shakeouts are long and painful. Why should this one, following on the heels of the mother of all bubbles, be any different?
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United States: Post-Bubble Purgatory or Reacceleration?
Richard Berner (New York)
The crisis in confidence in corporate governance has spilled from Wall St. to Main St., likely keeping US real economic growth at a tepid 2 1/2;% to 3% pace for the balance of the year. Such lackluster growth and an uncertain geopolitical backdrop are now largely in the price for most financial markets. Thus, I think the real question for investors is whether further post-bubble paybacks condemn the US and the global economies to sluggish growth into next year and beyond. In my view, the answer is no. With one exception -- our gaping current account deficit -- an elongated period of slow growth has reduced or eliminated many US economic imbalances. And today's U.S. economy, in my opinion, bears little resemblance to that of the past, when financial panics alternated with booms to produce comparatively long recessions and short expansions. If today's uncertainty begins to fade -- and I acknowledge that's a big if -- I believe that the US economy's underlying growth potential will begin to resurface strongly by early next year.
Uncertainty is the enemy of growth, because it breeds hesitation among consumers, businesses, and lenders. In turn, that creates downside risks to spending, hiring, and the flow of credit. At further risk are both consumer and capital spending. Consumers have slowed the pace of spending but are far from retrenching, because income growth has improved, enabling them to sustain spending and rebuild saving in an uncertain economic climate. Good news has arrived in the form of zero-interest-rate financing on new vehicles, and a new wave of mortgage refinancing that will free up additional discretionary income. But the combination of plunging stock prices, a reversal of income gains, and uncertainty about job prospects could promote more consumer hesitation in the next few months.
Likewise, while capital spending began to make a comeback this spring -- strong evidence that the capital stock overhang is now small -- business managers have no doubt become more preoccupied with certifying financials than committing to new projects. That hesitation is reflected in June's plunge in durable goods orders and in weak July bookings from purchasing managers. Finally, lenders are asking for more collateral and higher spreads to compensate for the uncertain climate. And they are reluctant to finance the important and growth-promoting process of "capital exit" -- the sale of distressed assets and paydowns or writedowns of debt -- when perceptions of value are still uncertain.
Such a slow pace leaves the economy vulnerable to new shocks. A slow-growing economy is one involving some growing industries but also some that are contracting. That patchwork quilt of strengths and weaknesses lacks the resilience that across-the-board hearty growth would provide. In fact, the governance cum wealth shock has clearly already taken a toll on business activity in July, and a new terrorist attack or a financial accident could create more hesitation and depress activity further.
But I think there is underlying resilience beneath the surface of recently weak data that make a double-dip downturn unlikely. Growth in income and profits is providing a cushion against shocks. For consumers, the news has been good: Real, after-tax wage and salary income (defined as real wages and salaries less withheld and state and local taxes) reaccelerated to a 5.5% annual clip in the six months ending in June from just 0.8% in the previous six months. And that acceleration occurred despite the ongoing slippage in income from the exercise of stock options that is counted in this tally. Likewise, corporate profits by any measure are growing again. Through August 1, with 84% of the companies in the S&P 500 universe reporting, earnings are up 5.2% from a year ago, and earnings gains in 6 of the 10 S&P sectors were strongly in double digits.
Are both now in jeopardy? July's weak employment data hint that income could be at risk; the 0.6% dip in July labor hours is clearly not good news for aggregate paychecks. But while Corporate America is clearly cautious about hiring, the improving breadth of employment change hints at underlying resilience. A so-called diffusion index of payroll change shows that half the 347 canvassed industries were hiring over the past three months for the first time since December 2000 (for analysis of such measures, see "Breadth Matters -- Again," Global Economic Forum, April 26, 2002). And the ongoing gain in real wages and salaries -- now running at a 2% to 2 1/2% rate by any metric -- provides moderate growth in spending wherewithal.
Likewise, July's 0.9% in factory hours spells slippage in production that is bad news for corporate profits. But recent healthy, procyclical gains in manufacturing productivity -- even after revision, they are lately running at 5% annualized -- speak to increased efficiency and lower unit costs that, courtesy of high operating leverage, are dropping right to the bottom line. To be sure, the more comprehensive measure of nonfarm productivity may have stalled in the second quarter, and the downward revisions to GDP will trim about half a percentage point from measured productivity over the past three years. But, in my view, the cyclical acceleration in productivity to an above-trend 4 1/2% growth rate over the past year (after revision) is consistent with potential economic growth in the range 3% to 3 1/2;%, and signals that the productivity improvement of the past seven years was no mirage.
However, even if the economy skirts the dreaded double dip, the case for economic reacceleration now seems remote. But that's now the point -- reacceleration certainly is not in the price of either the equity or fixed-income markets, so is worth considering. In my view, four factors seem likely to promote a pickup in growth. First, the Fed will do what it takes to support growth, and certainly keep monetary policy accommodative for the balance of the year. While officials won't respond quickly to emerging economic weakness, they may decide to ease again if labor-market conditions and demand were to deteriorate further. Second, the longer today's hesitation in both consumer outlays and business capital spending lasts, the more likely it will create tomorrow's pent-up demand.
Perhaps most important, I believe that today's uncertainty will fade, as clarity emerges in financial reporting, as corporate malefactors are punished, and as the domestic and overseas geopolitical fog begins to lift with elections both at home and abroad. That may not usher in a new bull market in equities soon. But given that a lot of bad news is in the price, with any reduction in uncertainty likely will come less hesitation and risk aversion in financial markets. And that will promote the easier financial conditions and bids for cheap assets that I believe will support an economic reacceleration next year.
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