Global: Deflationary Perils of a Dysfunctional World
Stephen Roach (New York)
Morgan Stanley
May 07, 2003
War, uncertainty, and disease are a tough combination for any economy.
But for a stalling and vulnerable global economy, this confluence of shocks
hurts even more. The result could well be a weak recovery or the world’s
second synchronous recession in three years. This could be a critical
tipping point for a low-inflation world that is already on the brink of outright
deflation. Is there a way out?
To a large extent, today’s deflationary perils reflect the inherent tensions of
an increasingly dysfunctional global economy. Two powerful forces are
colliding to produce this outcome -- the first being the lopsided, US-centric
nature of the global economy. Since 1995, growth in US domestic demand
has averaged 4%, double the 2% gains elsewhere in the world. Courtesy of
bubble-induced wealth effects, Americans have spent to excess. At the
same time, reflecting ever-deepening structural constraints, domestic
demand has remained decidedly subpar in Japan, Europe, and most
everywhere else in the world. As a result, America accounted for literally
64% of the cumulative increase in world GDP over the 1994-2001 interval --
double its share in the global economy.
This dichotomy is neither costless nor sustainable. A saving-short US
economy has had to import surplus saving from abroad, mainly from Asia
but also from Europe, in order to support economic growth. And the US has
had to run a massive balance-of-payments deficit in order to attract that
capital. As America’s federal budget now goes deeper into deficit, the
country’s net national saving rate -- for consumers, businesses, and the
government sector combined -- could easily plunge from a record low of
1.3% in late 2002 toward “zero.” In that case, the US current-account deficit
could approach 7% of GDP, requiring about $3 billion of foreign financing
every business day. The world has never before faced an external financing
burden of that magnitude.
America’s post-bubble hangover is a second key force shaping the world.
Most of the excesses that built up in the United States in the late 1990s
endure. Whether it’s the current-account deficit, anemic national saving, or
the overhang of private sector indebtedness, all of these measures remain at
historic extremes. The result is the functional equivalent of stiff economic
headwinds that act to constrain the speed of the world’s only growth
engine. Just as the US economy expanded at nearly a 4% average annual
rate in the late 1990s -- one full percentage point above its productivity-led
trend -- the persistence of structural headwinds implies a below-trend
outcome of around 2% per annum in the first half of this decade.
The confluence of these two forces -- a US-centric world and a post-bubble
US economy -- sets the stage for the world’s deflationary perils. It paints a
picture of lingering subpar growth in the global economy that should
continue to open up ever-wider margins of slack between the
bubble-induced excesses of aggregate supply and the post-bubble
compression of aggregate demand. The jury is out on whether the world will
either tip into its second contraction in three years or merely experience a
synchronous slowdown. For a low-inflation world, however, either outcome
generates more slack, thereby upping the ante on deflationary risks.
But there’s far more to the deflationary saga than the vicissitudes of the
global business cycle. Also at work is a residue of excess supply -- an
enduring legacy of the bubble that was spawned by the capital spending
and hiring binges of the late 1990s. In that key respect, the American
disease bears an eerie resemblance to the Japanese strain. In both nations,
the bubble in equity markets went on for long enough, and rose high
enough, to convince corporate managers that scale and technology
acquisition were a surefire recipe to garner bubble-like multiples in the stock
market. Once the equity bubble popped, there was an urgent need to trim
the overhang of excess capacity -- a development that gave rise to
America’s first post-bubble recession since the 1930s.
The capital-spending-led recession of 2001 stands in sharp contrast with
past US downturns, which mainly reflected declines in consumer durables
and homebuilding activity brought about by the anti-inflationary resolve of
the Federal Reserve. Supply-induced recessions of the post-bubble era are
strikingly reminiscent of the boom-bust cycles of the late 19th century and
the early 20th century -- downturns spawned by speculative excesses in
asset prices and concomitant overhangs of excess capacity. The history of
those earlier cycles suggests that post-bubble adjustments are typically
long and arduous -- meaning that recessions tend to be lengthier and
recoveries are usually more subdued and fragile as a result. Japan’s
multi-dip syndrome of the past 13 years is a case in point. So far, America’s
post-bubble experience seems to be cut from similar cloth.
Globalization is a third leg to the deflation stool. In its early stages,
globalization is mainly about new increments to global supply. Courtesy of
trade liberalization, rapid dissemination of new technologies, and
market-driven structural reforms, low-cost, high-quality production
platforms are expanding rapidly in nations like China. As trade barriers come
down, worldwide prices of tradable goods converge on the lowest common
denominator -- an inherently deflationary transition.
The big surprise is that a similar phenomenon is now playing out in
“non-tradable” services. Deregulation of once sheltered services industries
is now global in scope, transforming administered pricing into market-driven
pricing for this vast segment of economic activity. Moreover, courtesy of a
surge of cross-border M&A activity, huge multinational service providers
now span the globe; as a result, service enterprises are operating more and
more with global rather than local supply curves. Finally, there’s the impact
of the Internet. With the click of a mouse, increasingly high-value-added
services can be extracted from white-collar outsourcing platforms in India,
China, and even Ireland. Once shielded from global forces, service sector
pricing is now feeling competitive pressures quite comparable to those
shaping the tradable goods sector.
The case for global deflation is not just theoretical conjecture. A large
portion of Asia is already in deflation, and inflation rates in the United
States and Germany are currently running at around 1%, as measured by
broad GDP deflators. America’s so-called “core rate” of inflation is receding
sharply. Excluding food and energy, the Consumer Price Index was
unchanged in March 2003 and was up at only a 0.8% annual rate in 1Q03.
That’s well below its previous cycle peak of 2.8% in late 2001 and sufficient
to bring the year-over-year comparison in March down to 1.7% -- nearly a
40-year low. In short, the industrial world is now in the midst of its most
worrisome flirtation with outright deflation in nearly half a century. It
wouldn’t take much to cross the line. As a dysfunctional global economy
now flirts with a double dip in early 2003, deflationary perils can only
mount.
It is not too late to avoid such a dire outcome. What is needed, first and
foremost, is a “global rebalancing” -- a world that breaks its US-centric
growth mold. This is unlikely to happen spontaneously. The world has
been reluctant to embrace the structural reforms that are necessary to
unlock the inherent efficiencies that would boost domestic demand. A more
powerful incentive is needed. One possibility would be through a
realignment of the world’s most important relative price -- the dollar. The
problem with this option is that most nations think that they deserve the
weaker currency. Japan wants a weaker yen and Europe feels it could
benefit from a weaker euro. But the economics is pretty clear on how
currency adjustments ultimately work. The nation with the current-account
deficit -- in this case, the United States -- is at the front of the queue. A
persistence of the so-called strong-dollar regime of the past eight years is
the last thing a dysfunctional world needs. It would continue to shelter the
non-US world, thereby inhibiting the heavy lifting of structural reform.
A weaker dollar could save the world from deflation. For the United States,
a shift in the “currency translation” effect would transform imported
deflation into imported inflation. For Japan and Europe, stronger currencies
would initially be painful. The appreciation of the yen and the euro would
undermine external demand, the only source of sustainable growth in these
economies in recent years. That would leave Japan and Europe with no
choice other than finally to bite the bullet on reforms in order to stimulate
domestic demand. The gain would be worth the pain. It would eventually
result in a more balanced mix of global growth -- less domestic consumption
from a saving-short US economy and more domestic demand from the
saving-surplus economies of Japan and Europe.
There is always a chance such a currency realignment might backfire. If the
non-US world chooses to deflect the pain of a weaker dollar, the risk of
competitive currency devaluations might intensify. That would take the
world down a very slippery slope of trade frictions and protectionism. The
recent outbreak of China bashing in Japan is particularly worrisome in that
regard. The Chinas and Indias of the world are not a threat. To the contrary,
they enable high-cost producers and service-providers in the developed
world to realize efficiencies through outsourcing. They also enable rich
nations to expand their purchasing power by buying cheaper, high quality
goods and services. There will also come a day when the supply-led
impetus of countries like China and India hits a critical mass in boosting
income generation and domestic demand -- completing the virtuous circle of
global rebalancing.
A dysfunctional global economy is at a critical juncture. An intensification
of deflationary risks is a real threat if an imbalanced world stays its present
course. As globalization continues to expand the supply side of the world
economy, a deficiency of aggregate demand becomes the real enemy. If
concrete actions are taken to boost the demand side of the global economy,
the deflationary time bomb will be defused. The heavy lifting of structural
reforms and global rebalancing is the only way out.
Note: This essay was published as an editorial feature in the Nihon Keizai
Shimbun in Japan on May 1, 2003.
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