Stephen Roach on Global: The Limits of Policy
(New York) Oct 25, 2002
Every time the financial markets have turned in the past couple of years, there’s talk that it’s about time -- that the long and variable lags of policy stimulus are finally kicking in. In a traditional business cycle, there’s nothing wrong with that logic -- it has worked repeatedly over the past 50 years. But in a post-bubble business cycle -- my operative depiction of today’s climate -- it’s a different matter altogether. Policy traction has been fleeting, at best. I fear that markets, which are basing future hopes on the traction of yesteryear, will continue to be disappointed.
For starters, it’s important to identify the points of contact between policy levers and the real economy -- those components of aggregate demand that are most sensitive to shifts in monetary and fiscal policies. In the case of the United States, three such sectors qualify -- consumer durables, residential construction, and business capital spending. Given the financing that underpins such outlays, these sectors are usually quite responsive to the ups and downs of interest rates as driven by shifts in monetary policy. If the policy lags are finally kicking in, as many presume, these are the sectors that should be leading the charge.
It’s certainly worked that way in the past. Take the cases of consumer durables and residential construction activity -- typically the most vibrant sectors in a cyclical recovery. Normally during a recession, these two sectors collapse. Indeed, on average, during the 28 quarters of the preceding six recessions, the combined impact of these two sectors alone was enough to lower annualized GDP growth by 1.2 percentage points. This created a condition that economists call "pent-up demand" -- the cars that aren’t bought and the homes that aren’t built. Once the cycle turns and the lagged impact of lower interest rates starts to kick in, such pent-up demand is then typically released. As this endogenous cyclical demand improves -- typically aided and abetted by policy stimulus -- business capital spending then usually responds with its own set of lags. This is the time-honored process of cyclical re-ignition.
It’s unlikely to work out that way this time. That’s because the same three sectors are likely to be inhibited by forces that are unique to this post-bubble business cycle. Take the cases of consumer durables and homebuilding. As opposed to collapsing as they normally do in a recession, these sectors continued to expand briskly -- having the combined impact of boosting annualized real GDP growth by 0.7 percentage point during the three-quarter recession of 2001. As a result, there is no pent-up demand that now gets unleashed -- it has already been spent.
A somewhat different force is at work in shaping business capital spending. Normally, cuts in capital spending lower annualized GDP growth by 0.4 percentage point in a typical recessionary quarter (also based on the 28-quarter average of the past six recessions). However, over the first three quarters of 2001, the impact was -1.1 percentage points -- nearly triple the drag of earlier cycles. At work, in my view, was the unwinding of one of the key excesses of the late 1990s -- the bubble-induced acquisition of information technology. IT alone accounted for fully 100% of the cumulative drop in overall real GDP during the recession of 2001.
Yet hope persists that a spontaneous resurgence of business capital spending is about to occur, sufficient to compensate for any shortfalls in homebuilding and consumer durables. The logic goes something like this: With fully 58% of total capital equipment spending now going to real IT outlays, the average life of the capital stock has gotten a good deal shorter in recent years. By definition, such short-lived capital has a higher obsolescence rate than the bricks and mortar of the industrial age. This suggests that the replacement cycle could kick in sooner than is normally the case, thereby imparting a new cyclical dynamic to the US economy.
Several things are wrong with that hypothesis, in my view. First, while the IT vendors insist that the replacement cycle is about three years long, tough economic conditions could well encourage businesses and consumer to defer upgrades for considerably longer. You may miss out on the latest tweak of your favorite operating system or application, but (gulp) so what? Second, there is a powerful consolidation and restructuring going on in the core of the IT user community -- mainly transactions-intensive service companies such as banks, insurance companies, securities firms, air transportation, telecom service providers, and even retailers. That means that when the IT replacement cycle finally does turn, there will be fewer buyers -- yet another reason to look for an anemic capital spending recovery.
Yet I often hear the argument that the recent pick-up in corporate profitability could be sufficient to outweigh all of the above -- turning a lagging sector into a cyclical leader. That’s highly unlikely, in my view. Back in the Jurassic Era when I was the Fed’s capital spending analyst, we used to monitor a wide variety of capital spending models -- those driven by profits, cash flow, cost-of-capital considerations, and the stock market (Tobin’s "Q"). But the model that always worked the best was derived from the so-called "accelerator theory" -- that business fixed investment was most sensitive to improving demand expectations and the concomitant impact a rising output trajectory would have on capacity utilization. If pressures on existing capacity were likely to get more intense, then you probably needed more of it -- it was that simple. For all of the reasons noted above, in today’s subdued demand climate, the accelerator effect is likely to remain muted, thereby continuing to inhibit business capital spending.
In short, I fear that counter-cyclical stabilization policies -- be they fiscal or monetary -- will have an exceedingly difficult time in offsetting the powerful structural pressures now bearing down on business capital spending. As the risks tip further toward deflation, the last thing businesses need is an expansion of productive capacity. It would only exacerbate the overhang of aggregate supply that is currently eroding pricing leverage. In such a climate, capital spending is not likely to be the spark that will spontaneously ignite economic recovery. I’ve never seen a capital-spending-led cyclical recovery in the US economy, and I don’t think this is likely to be the first such example.
Which brings us back to the basic dilemma of policy traction: If 475 bp of monetary easing and nearly four percentage points of fiscal stimulus haven’t yet sparked meaningful cyclical revival, why should we expect another dose of stimulus to do the job? That question is all the more relevant when the structural hangover of the post-bubble US economy is overlaid on the dysfunctional business cycle described above. Two key aspects of this structural hangover are particularly worrisome -- low personal saving and the excesses of private sector debt. They are the functional equivalent of powerful headwinds that could well inhibit growth in discretionary consumer and business spending for some time to come. Nor are these headwinds likely to be tempered by further monetary or fiscal policy stimulus.
All this underscores the dark side of a post-bubble climate -- a US economy encumbered by a legacy of excess that cannot be remedied by the quick fix of traditional stabilization policies. Largely for that reason, I continue to favor a shift in America’s dollar policy as the one option that could trigger a long overdue rebalancing of a lopsided global economy. Not only would such an action help reverse the strain of imported deflation that is bearing down on the US, but it would also put pressure on other countries/regions -- notably Euroland and Japan -- to adopt pro-growth policy measures of their own. Most importantly, the currency lever may well be the only major policy instrument that can still achieve traction in an increasingly deflationary world. For a post-bubble US economy, that traction runs the risk of becoming the most precious commodity of all. Policy always has its limits, but in today’s climate those limits have never been more apparent. |
