When Shocks Matter, by Stephen Roach (from Singapore)
Feb 28, 2003
Not all shocks are alike. Nor do they exert comparable impacts on macro economic performance. Shock analysis has two critical dimensions -- the magnitude and duration of the shock itself, as well the pre-shock condition of the affected economy. On both counts, the oil shock of 2003 is extremely worrisome. That leads me to conclude that the risks of renewed recession in the US and in the US-centric global economy are high and rising.
There are times when it pays to be overly-simplistic on the global macro call. This is one of those times. Three key points are most obvious to me insofar as the cyclical prognosis for the world economy is concerned: First, in a US-centric world, the global call is basically a call on the US economy. Second, the US is in the midst of a classic oil shock. And, third, that shock has occurred at a point of maximum vulnerability -- when a US-centric industrial world had slowed to a virtual standstill. The conclusion is inescapable: The recession warning model that I have long advocated is now flashing a serious alert for the US and for the US-centric global economy. A stalling economy lacks the cyclical immunities that cushion it from an unexpected blow. A stalling economy that has been hit by a shock is a recipe for recession. Unfortunately, it's that simple.
It's educated guesswork as to where oil prices are headed. It's a painful reality check to see where they have come from. Crude oil (WTI spot) prices have now pierced the $37 threshold -- fully 89% above the level prevailing in January 2002. Moreover, as of the close of February 27, oil prices have now equaled the highs of $37.20 hit on September 20, 2000, that played an important role in triggering the recession of 2001. With oil inventories low, disruptions in Venezuela lingering, and war looming, the risk is that oil prices will move higher before they begin their fairly typical post-shock mean reversion. But those risks lie in a murky and uncertain future. At this point in time, the facts speak for themselves -- an oil shock has already occurred.
In and of themselves, shocks don't always cause recessions. That's where pre-shock resilience comes into play -- the economy's ability to withstand the blow of a shock. Sadly, the industrial world is far from being resilient at this point in time. The world's three largest economies -- the United States, Japan, and Germany -- were all in lousy shape as 2002 came to an end. The US economy inched ahead at just a 0.7% annual rate in 4Q02, and Germany's growth rate was estimated at "zero." Ironically, Japan was the strongest of the lot, with a +2.0% sequential annualized growth, but most have been quick to dismiss this estimate as statistical hocus-pocus for an otherwise weak Japanese economy (see Takehiro Sato's February 24 dispatch, "The National Accounts vs. Reality"). To me, the conclusion is inescapable: With the industrial world at its stall speed, the current oil shock -- to say nothing of the related confidence shock -- hurts a good deal more than would be had been the case in a more vigorous growth climate.
Critical to the prognosis are the factors that have led to the stalling -- in this case, the pre-shock vulnerability of a US-centric world. America's post-bubble shakeout is at the top of my list in setting the stage for the extraordinarily fragile cyclical outlook of the past several years. With pre-bubble excesses lingering -- namely record lows of national saving, record highs of private sector indebtedness, and an unprecedented current-account deficit -- the US economy faces unusually stiff headwinds. The lack of pricing leverage in an increasingly deflationary climate is the coup de grace. That keeps Corporate America fixated on cost-cutting in an effort to generate earnings, thereby inhibiting capital spending and hiring. The result is a US economy that has been lacking in its traditional cyclical sustenance -- unable to respond to the massive policy stimulus that has since been unleashed. In that critical respect, America's policymakers are going through a very Japanese-like experience of "pushing on a string" in a post-bubble era. With Washington contemplating deficit spending not seen since the early 1980s, that frustration is likely to mount.
America's post-bubble shakeout was central to my recession call in early 2001 and has been equally crucial to the double-dip warnings that I first issued a little over a year ago. The post-bubble shakeout keeps the US economy dangerously close to its stall speed, thereby leaving it more vulnerable to shocks than might otherwise be the case in a more vigorous growth climate. The previous oil shock of 2000 needs to be interpreted in that context. The spike of crude oil to $37.20 per barrel on September 20, 2000, represented a 49% increase from levels prevailing a year earlier -- only about half the current surge in oil prices. Yet that earlier shock hit a vulnerable US economy just as it was entering its post-bubble shakeout. As such, it played an important role in contributing to the ensuing recession of 2001. It may not have been the decisive blow but, in my view, it was very much a central player in that cyclical saga. And the outcome only served to underscore the key role that oil plays in shaping the ups and downs of the US business cycle: Since the early 1970s, there's never been an oil shock that was not followed by recession.
The notorious double-dip call needs to be seen in that same vein. In my view, lingering post-bubble excesses have inhibited cyclical recovery from the recession of 2001 and have left the US economy unusually vulnerable to another shock. After contracting over the first three quarters of 2001, the US economy has grown at just a 2.7% average annual rate over the ensuing five quarters -- an anemic recovery by any cyclical standards of the past. Moreover, about one-fifth of that growth was driven by a temporary inventory dynamic that reflects the termination of the massive inventory liquidation that occurred in late 2001. The resulting final demand trajectory of just 2.2% over the past five quarters spells nothing but stall speed, in my view -- leaving the US highly vulnerable to a shock. The twin shocks of surging oil prices and the geopolitical battering of the American psyche need to be seen in that context. The odds of a recessionary relapse are high and rising in my view. In this critical respect, the dreaded double dip needs to be seen as nothing more than yet another symptom of America's post-bubble malaise.
No two shocks are alike. But their macro impacts can be categorized rather neatly. If a shock hits a rapidly growing economy, it usually doesn't inflict much pain. But if a shock hits a slowly growing economy that is hovering near its stall speed, then it can easily take on the role of the "tipping point" -- the event that pushes the economy back over the cyclical edge. It is the latter set of circumstances that applies to the current economic prognosis. For the second time in three years, the recession alert needs to be taken quite seriously. In my view, renewed recession is a clear and present danger for today's US economy. It is also the key risk for a US-centric world.
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