Global: The Lessons of 2002
By Stephen Roach
Morgan Stanley - New York
Jan 06, 2003
Those of us in the forecasting business often get criticized for spending too much time looking in the rear-view mirror. And at, at times, with good reason. After all, there is no guarantee that the past is a prologue to what lies ahead. But I still believe that it pays to take a retrospective look from time to time. Otherwise, mistakes are quickly forgotten, and little is learned as we turn the page on our tattered calendars. In that spirit, I present the five economic lessons of 2002.
Not surprisingly, the perils of deflation are at the top of my list. A year ago, when I first started warning of the "three Ds" -- double dip and deflation -- I was dismissed as something of a crackpot. That was then. While the double-dip never quite came to pass, there were two very close calls over the course of 2002. But the case for deflation has gained new prominence. It is now the operative macro risk shaping stabilization policies in Japan and the United States, and my guess is that the Euro authorities can’t be too far behind. The lesson from all this is that the days of an asymmetrical focus on inflation fighting are now over. Under certain circumstances, low inflation can, indeed, morph into deflation.
A corollary to that lesson is the macroanalytic inference that "output gaps" matter. The output gap is economists’ jargon for the disparity between aggregate supply and demand. In recessions, the gap widens due to a cyclical shortfall in aggregate demand; the resulting overhang of excess supply lowers the market-clearing price level -- a classic disinflationary outcome. That balance typically swings the other way in recovery, as a bounce-back in aggregate demand absorbs the scaled- back capacity of aggregate supply. The problem comes with anemic recoveries at low rates of inflation -- precisely the situation today. Such a sluggish growth outcome would see the inflation rate continuing to move lower, perhaps even breaching the "zero" threshold.
In that context, today’s deflation risks are global in scope. That’s a key by-product of our baseline forecast of the world economy -- a 2.9% estimate for world GDP growth in 2003 following two years of gains averaging just 2.1%. Not only did the 2001-02 outcome fall a cumulative 3.0 percentage points below the global economy’s longer- term 3.6% growth trend, but our 2003 scenario adds another 0.7 percentage point to the global output gap -- perpetuating the deflationary tendencies of this subpar global growth cycle. Moreover, our first cut at 2004 -- a 3.9% increase -- is only 0.3 percentage point above trend, thereby barely making a dent in the outsize imbalance between global supply and demand. Consequently, notwithstanding the recent pop in commodity prices, traditional macro tells us that a persistently wide global output gap makes it difficult to envision the return of pricing leverage at any point in the foreseeable future. The risk of global deflation can hardly be ruled out.
The second lesson is that post-bubble economies remain vulnerable to periodic setbacks for a lot longer than most believe. That’s certainly been the lesson from Japan’s last 13 years and it has also been the case in the United States since the equity bubble popped in March 2000. The reason: Most asset bubbles -- especially the big ones -- ultimately infect the real economy and its balance-sheet underpinnings, leading to a build-up of excesses that must be worked off before economic growth can return to a satisfactory pace. America has made some progress in purging its post-bubble excesses, but these efforts have been confined to the corporate sector, where capital spending has been slashed and balance sheets restructured. The purging of other key post-bubble excesses has yet to begin -- especially those of the American consumer, who remains out on a limb of record indebtedness and subpar saving.
The persistence of post-bubble excesses is the essence of my double- dip fixation. Structural imbalances are the functional equivalent of "economic headwinds" -- forces that restrain the pace of activity from returning to trend on a sustainable basis. Persistently subpar growth doesn’t leave the economy far from its "stall speed," a weakish growth outcome that all but eradicates the cyclical immunities that are needed to fend off the downside pressures of periodic shocks. In the case of the US economy, I would place the stall speed in the 1-2% zone. At the same time, my guesstimate is that the post-bubble US growth rate will hold in the 2% range for at least the next year, somewhat below our official estimate of 2.7%. As was the case over the four quarters of 2002, there will be times when growth is well above this subpar norm (i.e., the first and third quarters). But it is equally likely, in my view, to look for quarters when the growth rate falls below 2% (such as the second and fourth quarters of 2002). Those all too frequent setbacks would find the US economy back in its stall-speed range, leaving it exceedingly vulnerable to any one of a number of shocks. Should such shocks occur -- hardly a trivial consideration given the sharp recent run-up in energy prices -- a recessionary relapse could ensue. The lesson of 2002, in my view, is that the double-dip watch is far from over.
The third lesson is that saving-short economies remain especially vulnerable. America is in a class of its own in that regard. Its net national saving rate plunged to a record low of 2% in 3Q002, literally one-third the subpar 6% average of the 1990s and about one-fifth the 10% norm of the 1960s and 1970s. The net national saving rate is the most important measure of domestic saving: It nets out the funds needed to replace worn-out capital, and it includes the combined saving of individuals, businesses, and government units. It is a basic economic truth that such saving must always equal net investment -- the sustenance of any economy’s longer-term economic growth potential. Lacking in domestic saving, the Unites States has had to turn increasingly to foreign savers to finance its ongoing growth. This has led to an unprecedented buildup of foreign indebtedness -- underscoring the potential for capital flight, which could have ominous consequences for dollar-denominated assets. The flip side of the resulting capital inflows is, of course, America’s record current-account and trade deficits, the external "leakage" that often sparks protectionist actions. The lesson of 2002 is that these external imbalances are deeply rooted in America’s chronic saving conundrum, an imbalance which may only get worse as the Federal government budget now moves deeper into deficit. This mismatch could well haunt us in 2003.
Which takes us to the fourth lesson -- the perils of a lopsided global economy. I have droned on about this one for a long time, but I continue to believe that the world is far too dependent on the United States as the sole engine of economic growth. One number says it all: Since 1995, our estimates suggest that America has accounted for 64% of the cumulative increase in world GDP -- double its share in the global economy. The rest of the world is utterly lacking in autonomous sources of domestic demand. Over the same seven-year period, domestic demand growth in the US has averaged 3.8%; by contrast, gains elsewhere in the so-called advanced world have been nearly 50% slower, having averaged only 2.0%. With growth prospects in Europe and Japan anemic at best, a perpetuation of this dichotomy seems likely. Therein lies a key aspect of the global conundrum: The stage is set for a further widening in the disparities of the current- account deficit nations (mainly the United States) and the surplus areas (Asia and Europe). These disparities are presently at extremes never before experienced in the post-World War II era. To the extent they widen further, a lopsided world can only become more precarious. That underscores the potential for a cross-border realignment of relative asset prices -- especially currencies but also stocks and bonds. Such imbalances are also a breeding ground for intensified trade frictions and geopolitical tensions. Those fears could well come to a head in 2003.
I suspect that the final lesson of 2002 could well be the hot topic of 2003 -- policy traction, or the ability of stimulus measures to work. To their credit, policy makers are now on board with many of the issues noted above. I suspect financial markets will initially take heart in the potential for these actions to work. That has led to my uncharacteristically bullish stance on world equity markets in early 2003 -- the so-called "reflation trade" (see my 16 December essay in Investment Perspectives). But I continue to have strong doubts as to whether those stimulative actions will truly deliver. The persistence of excesses suggests that a "structural purging" could well take precedence over a prompt revitalization of aggregate demand. That’s especially the case if businesses continue to cut costs in a "no-pricing- leverage world," and even more so if the onus of such cost cutting falls on workers/consumers.
To that end, I must confess to being highly suspicious of the sure-thing monetarist answer to deflation that is now in vogue in official policy circles. Sure, there is a lot of liquidity flowing into the system right now, but there are no guarantees that it won’t be absorbed by the imperatives of balance sheet repair. Finally, I would stress yet again that America’s most policy-sensitive sectors -- consumer durables, homebuilding, and capital spending -- have all gone such to excess in recent years that it’s hard to envision the upside from here. Consequently, notwithstanding recent reflationary actions, there are no guarantees that policy makers don’t end up pushing on a string, a classic pitfall of a post-bubble economy. In my view, a US-centric world remains vulnerable to just such a possibility. Investors have long been taught not to bet against the authorities. Those bets, however, need to take account of the perils of a post-bubble era. My fear is that the lack of policy traction in 2002 could well be a hint of what lies ahead in 2003.
I’ve left a lot out in this discourse. But I can’t close without straying from my perch and offering a market-based lesson from 2002 that seems particularly apt as we peer into 2003. The standard line I hear from equity investors these days is that we simply can’t have a fourth down year in a row. After all, we hadn’t seen three consecutive annual declines in some 60 years. Another down year would hearken back to the rout of 1929-33, utterly inconceivable to most. Unfortunately, this is precisely the same logic that was used on the upside of the Roaring Nineties. Beginning with the unlikely outcome of three consecutive double-digit up years, there was doubt all the way up. By the time the fifth year came along, the lessons of history had been completely tossed aside. Now, a similar mind-set lurks on the downside. With all due respect to the consensus, this debate is not about numerology. It’s about picking up the pieces from the greatest bubble in modern history.
morganstanley.com |
