Global: Shocks and Landings
Stephen Roach (New York)
In these days of mounting geopolitical angst, sharply rising oil prices, and Chinese overheating, we tend to dwell understandably on the threat of shocks. Yet in doing so, we risk ignoring even more basic problems — namely, the profound state of disequilibrium that still exists in this $36 trillion world economy. That could be a critical oversight. A stable world is better able to withstand the impact of shocks than is an unstable world. Until the global economy makes more progress on the road to rebalancing, recoveries such as the one under way are likely to remain tenuous. That remains the biggest risk of all as I peer into 2005.
Global equilibrium, in my view, is attained when there is balance in the world’s growth dynamic. It occurs when nations are making a contribution to gains in global GDP that is commensurate with their shares in the world economy. Global equilibrium also exists when there is only a small difference between the world’s current account deficits and surpluses; that would imply that investment requirements of the major countries of the world would be well supported by internal saving capacities. On both counts, today’s global economy remains in a serious state of disequilibrium. Over the 1995 to 2002 period, the US accounted for an astonishing 98% of the cumulative increase in world GDP, more than triple its 30% share in the global economy. While there were some tentative signs of rebalancing in 2003, by my reckoning, 90% of the task remains unfinished (see my May 14 dispatch, The Long Road). At the same time, the disparity between the world’s current account deficits and surpluses remains at an all-time record, close to 3% of world GDP. As America’s unprecedented $46 billion trade deficit for March 2004 attests, these imbalances are an enduring feature of the global macro climate.
[in the long run this should be good for gold - mish]
A world in disequilibrium can also be seen as a collection of unbalanced economies. As such, rebalancing on a country-specific basis is equally important in establishing a new global equilibrium. That’s especially the case when internal adjustments are needed by the main engines of the global growth dynamic, which is precisely the case today with respect to the US and China. The US economy must now come to grips with the normalization of interest rates; pressures will be especially acute on the American consumer, long the mainstay on the demand side of the global economy. At the same time, an overheated Chinese economy must now come to grips with a policy-induced cooling; this will put pressures on the Chinese producer — increasingly the mainstay on the supply side of the global economy. How the US and China cope with their own imbalances is critical to the world economy’s success or failure on the road to rebalancing.
This takes us to the critical distinction between the hard and soft landing — a debate whose outcome is nothing short of critical for financial markets. More often than not, financial markets overshoot and discount the hard landing at a time when the soft landing is around the corner; the 1994 inflation scare in global bond markets and the crisis-induced seizing up of world capital markets in the fall of 1998 are clear examples. Yet there are also times when investors remain in denial over the downside and eventually are blindsided by sharp adjustments; Japan’s lost decade of the 1990s and America’s equity bubble in the late 1990s are particularly painful examples of that phenomenon.
Insofar as the landing in China is concerned, there can be no mistaking the preconceived notion: The West always seems to expect a hard landing in China. Yet in three instances over the past decade, China has proved the doubters wrong — the overheating of 1993-94, the Asian financial crisis of 1997-98, and the synchronous global recession of 2001. On each of those occasions, the broad consensus of investors was expecting a hard landing in China. The landings, however, all turned out to be soft. China’s macro managers have become very adept at avoiding the wrenching adjustments that gave rise to all-too-frequent boom-bust cycles of the past. I have confidence that China’s new leadership will prove to be equally skilled.
It is also worth stressing that today’s Chinese economy is in much better shape than it was in 1993-94 — the last time the nation faced serious internal imbalances. Back then, inflation peaked out at 22%, well in excess of the current 4% inflation rate. Back then, an investment bubble was reinforced by a consumption bubble; today, it’s only the investment cycle that has gone to excess. Moreover, the investment bubble of a decade ago was largely an outgrowth of state-sponsored excesses; the current investment dynamic reflects the mixed impetus of public and private spending. To the extent that private sector investment is driven by market-based returns, the risk of a misallocation of capital would be lower. The same is true of vulnerabilities in the Chinese banking sector. A decade ago, there was no focus on credit quality and nonperforming bank loans; the current focus on banking reform forces China to pay much greater attention to the integrity of its financial system. Inasmuch as the seriously unbalanced Chinese economy of a decade ago managed to sidestep a hard landing, I am confident that the intrinsically stronger Chinese economy of today will be equally successful (see my April 23 dispatch, The Wise Men of China). Consequently, I remain in the China soft landing camp.
The American consumer is a different matter altogether. I have to admit that since I’ve been dead wrong on the US consumption prognosis over the past year, you’re entitled to take my case with more than the usual grain of salt. But stubborn to the end, I remain convinced that an income-short American consumer cannot sustain an asset-driven lifestyle indefinitely — especially since the Federal Reserve is about to change the interest rate underpinnings of financial and property markets. Not only could the coming normalization of monetary policy challenge the valuation of such assets but it could also prove to be a very worrisome development for overly indebted US households. The hope, of course, is that the recent pickup in job creation comes just in time to spark a resumption of income generation that would temper any pressures in the asset-driven underpinnings of consumer demand. Such an exquisitely timed transition would be nothing short of miraculous, in my view. But stranger things have happened.
Long ago, my first boss, Fed Chairman Arthur Burns, admonished me never to bet against the American consumer. Burns was the foremost expert on the US business cycle at the time and believed that personal consumption could never contract over the cycle — that only its growth rate could slow. Unfortunately, that bias caused him to miss the severe consumer-led recession of 1973-75. It was a bias that was also wide of the mark in the wrenching contraction of the early 1980s and one that even missed the consumer-led dynamic of the mild recession of 1990-91. But other than those instances, as well as a temporary free fall when credit controls were imposed briefly in 1980, the Burns adage has been pretty close to the mark. I think about that a lot when I ponder the amazing staying power of the American consumer over the four years since the equity bubble has burst. But I also think about the extreme imbalances that have come about in order to sustain this extraordinary burst of consumption growth — namely, open-ended budget deficits, sharply reduced saving, a massive current account gap, and record increments of household sector indebtedness. While financial markets remain convinced that US consumers will once again find a painless way out, I am still concerned about a much rougher landing.
Landings and shocks are a tough combination for any economy. But for a severely unbalanced global economy, the interplay is likely to be all the more daunting. With oil prices now surging through the $40 threshold, the possibility of a full-blown energy shock that would come with $50 oil can hardly be ruled out (see my May 10 dispatch, Global Wild Cards). Moreover, the increased undercurrent of geopolitical angst, together with the related threat of global terrorism, sets the stage for another potential shock. But the true shock, of course, is that proverbial “bolt from the blue” — the unexpected development that takes financial markets, policy makers, and real economies by real surprise. Today’s unbalanced global economy is simply not prepared to withstand such a blow, in my view. Nor are the world’s two main growth engines, the US and China, each of which must now face some important internal adjustments of their own.
The implications for financial markets cannot be minimized. In assessing the landing risks in the current climate, I find myself more optimistic on the possibilities in China than in the US — precisely the opposite of the current risk assessment in financial markets. However, there are systemic risks to ponder. Imbalances speak to the intrinsic instability of economic systems. Borrowing from physics, the last thing an unstable system needs is a shock. And yet the risks of just such a disturbance have never seemed higher. Far-fetched as it seems, the possibility of a more perilous endgame is rising.
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