Global: The Lessons of 2003
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By Stephen Roach (New York)
Morgan Stanley
Jan 05, 2004
Whereof what’s past is prologue, what to come
In yours and my discharge.
— William Shakespeare, The Tempest
The lessons of history shape all of us who are charged with the seemingly impossible task of predicting the future. They are the anchor for what could otherwise be an all-too-serendipitous task. There is always the risk that we become captives of an immaterial past that offers little insight into what lies ahead. The trick is to know which lessons from history are most relevant. Last year was a case in point insofar as the global economy was concerned: The “science” of modern-day macro was challenged as never before. Many of the old rules were shattered, while some time-honored relationships held up much better than expected. And so as the New Year begins, it is important to take stock of what worked and what failed with respect to last year’s predictions. I know of no better way to learn from my own mistakes. In that spirit, I present the five lessons of 2003.
The first lesson pertains to policy traction — in particular, the ability of the authorities to jump-start a sluggish US economy with traditional counter-cyclical policy stimulus. This was a painful lesson for me. I had long argued that a post-bubble US economy would be surprisingly unresponsive to the combined impacts of fiscal and monetary stimulus. I was convinced that the lingering excesses of the late 1990s would dampen the multiplier effects that have long been at the heart of traditional macro — in effect, leaving the authorities “pushing on a string.” While this view was borne out over the first seven quarters of recovery in the form of an unusually anemic 2.6% average annual GDP growth pace, I stayed with the call for too long. With the US economy surging at a 6% annual rate in the second half of 2003, a loud mea culpa is in order.
As I do a post-mortem on my own prognosis, two errors jump off the page: First, I failed to anticipate the size of the fiscal stimulus package that was enacted in the spring of 2003. The tax cuts alone were worth 1.5% of GDP in the year after enactment — fully double our initial expectations. Add in close to another 1% of stimulus associated with the war in Iraq and its subsequent postwar rebuilding efforts, and the total fiscal thrust is right up there with anything we have seen in the past. Second, I made a classic forecasting error in underestimating the spending proclivity of the American consumer. That tells me one of two things — either consumers aren’t as over-extended as traditional metrics on saving, debt, and earned income generation suggest, or that they cast all caution aside and indulged in an unsustainable buying binge in 2003. I must confess to still being sympathetic toward the latter explanation: Two consecutive quarters of growth in durable goods consumption averaging 23% in the second and third quarters of 2003 — something that hasn’t happened in over 30 years — makes me especially concerned that a payback is coming. But for now, that’s only a hunch, and a still-painful one at that.
Getting the consumer wrong is all too often the most common error for any forecaster. That was certainly the case for me in 2003. The error gets compounded since perceptions of end-market demand are typically key in driving the “derived demands” of business capital spending and inventories. And both of these sectors kicked in with a vengeance in 2003 as well. Personal confession: This mistake takes me back to my formative days as a forecaster. Back in the early 1970s when I was a pup toiling on the research staff of the Federal Reserve Board, we presented a consumer-led recession forecast. Oil prices had quadrupled following the first OPEC shock of late 1973, and the consumer was being hit with a massive shock to real income. The then-legendary Fed chairman, Arthur Burns, dismissed this forecast and personally admonished me to “never underestimate the staying power of the American consumer.” Unfortunately for Burns, he got the call wrong and the modern-day US economy tumbled into one its worst recessions on record. Yet those words now ring louder than ever in my own ears. There’s obviously an important corollary to this lesson: Don’t underestimate the politics of reflation. When faced with election-year perils due to a sluggish economy, the political economy of desperation knows no limits.
The second lesson is all about the perils of America’s post-bubble shakeout. These perils manifested themselves in two ways — in the form of a double dip and through a full-blown deflation scare. Contrary to the perma-optimism of the forecasting consensus, it turns out that the US economy has been in exceedingly precarious shape in the aftermath of the greatest speculative bubble of modern times. The resulting vulnerability has had a significant and lasting impact on the economic climate over the past four years, not only by muting the upside of the business cycle but in creating a confluence of structural imbalances that have lasting secular impacts.
With the benefit of hindsight in the form of a comprehensive revision to government statistics released in December 2003, it is now evident that the US economy did, in fact, experience a double-dip recession in the aftermath of the burst equity bubble. Real GDP growth first entered negative territory in 3Q00, then rebounded modestly for a quarter before lapsing back into three consecutive periods of contraction over the first three quarters of 2001. This down-up-down pattern in the real economy is very much in keeping with the time-honored tendencies of the US business cycle — double dips that have now occurred in six of the seven full-blown recessions since the late 1950s.
My fellow macro practitioners have been quick to dismiss this after-the-fact validation of one of my more controversial calls. Yes, the double dip came sooner than I had originally thought (see my January 6, 2002 essay, Double-Dip Alert). But the point all along was to stress the protracted vulnerabilities of a post-bubble US economy — vulnerabilities that could not be easily neutralized by the mildest and shortest recession on record. Not only does the government’s statistical recasting of the data now vindicate this view, but the subsequent deflation scare underscores the lingering perils of this shakeout. The core CPI stood at just 1.1% (y-o-y) in November 2003 — a 40-year low; stripping out statistical bias corrections that are currently boosting this gauge of inflation by about 0.75%, the US remains dangerously close to the deflation threshold. Yet there’s no looking back for the momentum crowd. Two quarters of vigorous growth have all but wiped away any vestiges of post-bubble angst. Given the worrisome build-up of structural imbalances that has been required to underwrite this recovery — a massive current-account deficit, an unprecedented household debt overhang, and record budget deficits — I still fear that more painful lessons may still lie ahead on America’s post-bubble journey.
Which takes me to the third lesson — that global imbalances do matter. For some time, I have been stressing the unsustainable character of the world’s US-centric growth dynamic. It’s not just that America accounted for 96% of the cumulative increase in global GDP growth over the 1995–2002 period. It’s that this uniquely lopsided strain of global growth has given rise to unprecedented disparities between the world’s current-account deficits (the US) and surpluses (mainly Asia and, to a far lesser extent, Europe). I have long maintained that the rebalancing of an unbalanced global economy can best be accomplished through a significant shift in the world’s relative price structure. As the world’s most important relative price, a weaker dollar was the most likely means by which these global imbalances could be vented. And that’s pretty much what’s happened over the past couple of years. Looking ahead, I remain of the view that the correction of the dollar that has already occurred — a decline of only about 11–12% in the broad trade-weighted index (in real terms) since early 2002 — is not sufficient to spark the US current-account adjustment that is so essential to global rebalancing. That tells me there’s more to come on the currency front — an outcome that continues to raise critical questions about the pace of the dollar’s decline (soft or hard landing) and the part that China plays in this adjustment process
The fourth lesson pertains to the oft-forgotten role of labor. In an increasingly deregulated and no-pricing-leverage world, the imperatives of cost-cutting remain intense. And in the high-wage developed economies, where labor compensation accounts for around 75% of total business expenses, that puts unmistakable pressure on employment. The Internet has become the new enabler in the search for labor-saving productivity solutions, connecting low-wage offshore labor pools in the developing world with supply chains in the high-cost developed world. The result is an increasingly powerful global labor arbitrage — not just in the manufacturing of tradable goods but now in what used to be called non-tradable services. This has led to a breakdown of the traditional relationship between hiring and aggregate demand in industrial economies, resulting in a new strain of “jobless recoveries.” IT-enabled “offshoring” has come into its own as a critical force shaping the global economy; it has also created a new set of tensions bearing down on trade liberalization and globalization. As political cycles swing into full gear in 2004, especially in the United States, I suspect that labor will become increasingly important in shaping the macro debate.
Finally, there’s the lesson of China: 2003 was a year when the world finally woke up to the “China factor.” While China is still a very poor nation — with a per-capita GDP only one-fortieth that of Japan — its outward-focused growth dynamic has become a critical force in reshaping Asia and the broader global economy. While the Chinese economy still makes up only about 4% of world GDP, its growth dynamic has become so powerful that it is now accounting for 15–25% of the world’s overall growth in GDP, trade, industrial production, and capital formation. Moreover, China has become a magnet for foreign capital — emerging as the world’s largest recipient of foreign direct investment in 2002 — that may well be diverting funds from other Asian economies. Largely as a result, China has come of age through a rapid integration into the global supply chain.
The increasingly tight interplay between China’s challenges and the problems affecting the broader global economy is likely to be an enduring feature of the macro climate. China’s ability to manage its own daunting reforms will undoubtedly have important consequences for the rest of the world; banking and capital market reforms are especially critical in that regard, as are ongoing reforms of state-owned enterprises and the related urgency for China to absorb displaced workers through new job-creating endeavors. With an open growth model, China’s successes in these areas are critical — especially in the context of the global labor arbitrage and currency pressures noted above. In 2003, the world learned that it must take China seriously as a major factor shaping the global economy. I suspect that there will be a good deal more to learn on this front in 2004.
This business is never lacking in learning opportunities. They pose the challenges that keep me coming back for more. Macro is not science. Not only does the context of the debate change, but the relationships that define that context are in a constant state of flux. There are times when you think you have it all figured out and there are times when you feel almost clueless. I’ve had my fair share of both over the years. Integrity compels us to learn from both extremes. The Lessons of 2003 are my own attempt at such critical self-examination.
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