*** Stephen Roach (8-4-03) ***
Global: Global Fix for Global Problems
Stephen Roach
Morgan Stanley - New York
August 4, 2003
I continue to believe it will be difficult to sustain any near-term improvement in the world economy. While a temporary quickening in the pace of global activity may now be hand, two key problems endure -- the risk of deflation and the likelihood of a US current-account adjustment. A resolution of these problems is complicated by policy fixes that have the potential to work at cross-purposes with each other. That not only compounds the endgame but it also makes for a most unstable outcome over the next few years.
The deflation fix is straight-forward -- boosting aggregate demand. The trick comes in the realm of policy traction -- in particular, whether conventional stabilization tools of monetary and fiscal stimulus can stimulate the cyclically sensitive segments of economic activity. In a normal business cycle climate, that’s not a serous concern -- it’s just a question of how much stimulus is required and when the lagged impacts ultimately bear fruit. In a post-bubble climate, however, policy traction is more difficult to achieve; that’s because the policy-sensitive sectors of consumer durables, homebuilding, and business capital spending invariably go to excess during and immediately after the bubble. In the absence of pent-up demand, the authorities can end up pushing on that proverbial “string” -- frustrated by their seemingly futile efforts to achieve policy traction.
The current-account adjustment is also straightforward -- the deficit nation(s) needs to boost exports and reduce imports, while the surplus nation(s) need to do the opposite. That’s especially true in the case of the United States -- now staring at the largest external imbalance in the modern-day history of the world economy ($544 billion in 1Q03). Inasmuch as the US trade deficit accounted for 87% of the US current-account deficit in 2002, the bulk of the adjustment can be expected to occur in the form of a realignment in the trade balance. There are two main avenues to the current-account fix: Deficit economies need to boost national saving, thereby weaning themselves from the need to import surplus saving from abroad. Conversely, surplus economies need to stimulate internal demand, redirecting their excess saving toward supporting domestic activity. Global imbalances are best addressed by shifts in relative prices. Inasmuch as the dollar is the world’s most important relative price, there is good reason to believe that a sharp weakening in the value of the US currency is essential to the global rebalancing that must begin to take place if the world’s current account imbalances are to be corrected.
The predicament comes in putting these two macro problems and their orthodox resolutions together. Dealing with each in isolation from the other could well compound the problems for an already dysfunctional world. For example, the anti-deflation remedy of boosting domestic demand could easily exacerbate America’s current account deficit. Such an outcome depends on the relative effectiveness of policy traction around the world. To the extent that that the US is the most successful in getting its demand-stimulus measures to work, US-centric traction would only compound global imbalances. Given lingering structural rigidities in Europe and Japan that continue to shackle domestic demand, that hardly seems like idle conjecture. Moreover, an acceleration of aggregate demand could also lead to a further build-up of debt -- both private and public; for a US household sector that already has already has a record debt load in excess of 80% of GDP, that would be a most worrisome development, in my view.
Similarly, it is not hard to conceive of how a current-account adjustment could exacerbate the world’s deflationary conundrum. America’s already massive external financing needs are likely to expand sharply further over the next 12-18 months. Currently, with the current-account deficit having risen in 1Q03 to 5.1% as a share of GDP, the US needs to attract about $2 billion of capital inflows per day. Looking out through the end of 2004, soaring Federal budget deficits could take the US external gap to 6.5% to 7.0% of GDP, requiring capital inflows of approximately $3 billion per day. To the extent that the relative price adjustment of America’s coming current-account adjustment is vented in the bond market, long-term nominal interest rates could rise sharply further. That outcome, in conjunction with a further intensification of disinflationary pressures, could result in a significant further back-up in real long-term interest rates that would have a contractionary impact on aggregate demand, further exacerbating the risks of deflation (see my August 1 dispatch, “Warning Shot”).
Moreover, to the extent that a weaker dollar becomes a key ingredient of America’s current-account adjustment, that could lead to an exporting of deflationary pressures from the US to the rest of the world. Indeed, a stronger euro and a stronger yen, in and of themselves, would have first-order implications that would be decidedly deflationary for Europe and Japan. To the extent these economies then respond to such pressures by embarking on the long-overdue heavy lifting of structural reform required to unshackle domestic demand, then the second-order effects would temper deflationary tendencies. But the lags between stronger currencies, reforms, and the ultimate payback of internal demand responses are long and variable. While Joachim Fels has noted that a strengthening of the euro has led to a significant recent acceleration in the pace of European reforms, he concedes that this process is still in its infant stages, at best (see his August 1 dispatch, “Reforming Europe”). In the meantime, there can be no mistaking the more immediate “zero-sum” implications of a currency realignment -- deflationary pressures merely shift from the current-account deficit economy (in this case the US) to those with current-account surpluses (mainly Asian economies but also Europe). That’s hardly a plus for dealing with global deflation.
There’s an added twist in relying on a currency realignment to drive current account adjustments -- the possibility of competitive devaluations and other counter-measures that would further constrain global activity. Japan is certainly doing its best to push the yen down; official data now reveal the full extent of its recent efforts -- a record $75 billion of intervention in foreign exchange markets in the first seven months of 2003. Europe hasn’t moved yet, but German Chancellor Gerhard Schroeder has already played the currency card in sending a warning to the ECB. And, of course, there’s the latest global fad -- blaming China for the world’s mounting economic difficulties (see my July 14 dispatch, “The Scapegoating of China”). To the extent that the perils of a dysfunctional world lead to cross-border trade frictions and protectionism, global trade can only suffer as a result. As we learned all too painfully in the 1930s, that could well be the most deflationary pressure of all.
It’s human nature to compartmentalize our problems -- treating one in isolation from the other. But the real-time global economy offers no such sheltered laboratory. The confluence of uniquely powerful pressures -- deflationary risks and global imbalances -- is here today and is not about to go away in short order. It’s always tempting to put aside these concerns -- especially if the world is now getting somewhat better. But time does not work to our advantage in finding a painless and easy way out. The real problem is that a dysfunctional world lacks a holistic game plan in dealing with issues that are truly global in scope. The only way out, in my view, is for the world to get together in the form of a summit meeting and set a global agenda for the restoration of balanced growth. A weaker dollar would have to be a key ingredient of any such agenda -- as would be structural reforms in Asia and Europe, reduced world trade barriers, and policies aimed at establishing a more balanced mix of global saving. The world gets poor marks for policy coordination over the past 15 years, in my view. That has to change -- before it’s too late.
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