Global: Trapped
morganstanley.com
Stephen Roach (New York)
With all due respect to the “soft-patch crowd,” maybe there’s something else going on. I continue to see the macro debate through a very different lens. Sure, there may be some temporary aspects to this spring’s global growth scare. But, in my view, there could well be a far more powerful force at work -- the ongoing post-bubble shakeout of the US economy. By default, that means a US-centric global economy could be trapped in the same quagmire.
I am not a chartist, but I continue to be struck by the eerie similarities between post-bubble patterns in Japan and America. Five years after the bursting of the US equity bubble, the Nasdaq continues to track the post-bubble Nikkei very closely. Is this merely a coincidence or, in fact, a visible manifestation of the long and drawn out perils of a post-bubble shakeout? I fully realize the indelicate nature of this question. Everyone -- from investors and recovering dotcomers to policymakers and politicians -- seems united in their conviction to dismiss this possibility as nothing short of blasphemy. Federal Reserve Chairman Alan Greenspan summed up the consensus view on this critical issue over two years ago, when he famously declared that “…our strategy of addressing the bubble's consequences rather than the bubble itself has been successful” (see his January 3, 2003, speech, “Risk and Uncertainty in Monetary Policy,” delivered to the annual meetings of the American Economic Association in San Diego, California).
The risk, in my view, remains that the Chairman may have been premature in taking this victory lap. In large part, that’s because history tells us that major asset bubbles have long and lasting consequences that are not easily remedied by conventional policies. While the painful experience of the 1930s is the most obvious example in modern times, Japan’s persistent deflation fully 15 years after the bursting of its bubble is hardly a lesson to take lightly. Nor, unfortunately, is the state of the US economy as it faces what may well be yet another pitfall in its own post-bubble journey.
The academic literature on bubbles is virtually unanimous in concluding that the central bank is the key actor in this story. Whereas bubbles are inevitably an outgrowth of excess liquidity, the post-bubble policy stance of the monetary authority is viewed as decisive for any recovery. Unfortunately, the success rate of post-bubble recovery operations is not high. Once the macroclimate enters the deflation-risk zone at low nominal interest rates, the escape path becomes exceedingly problematic. Mindful of this tough history, America’s Federal Reserve was quick to lay out a different game plan (see the well-known International Financial Discussion paper published in June 2002 by the Fed’s staff, “Preventing Deflation: Lessons from Japan's Experience in the 1990s,” by Alan Ahearne; Joseph Gagnon; Jane Haltmaier; and Steve Kamin et. al.). The main lesson from this research is that the central bank needs to move quickly and aggressively in the aftermath of the bursting of an asset bubble. On that count, the Fed’s post-bubble reaction was quite different from that of the Bank of Japan. Whereas the BOJ kept tightening aggressively fully two years after the Nikkei bubble popped in December 1989, the Fed began easing within nine months after the bursting of the US equity bubble in March 2000. The key question is whether the Fed’s approach has worked.
In my view, the jury is still out on America’s post-bubble travails. In large part, that’s because the Fed has not been able to extricate itself -- or the US economy -- from the low real interest rate policy it adopted in the aftermath of the burst equity bubble. Fully five years after Nasdaq 5000, the federal funds rate remains basically “zero” in real terms -- a 2.75% nominal rate that is still negative when judged against a 3.1% headline CPI inflation rate and slightly positive when measured against a 2.3% core inflation rate. By holding the real policy rate at or below the zero threshold for such a long period, the Fed has nurtured the development of the Asset Economy -- dominated by American consumers who have become dependent on the persistence of low real interest rates and the concomitant wealth effects generated by a steady stream of asset bubbles. With the equity bubble now having morphed into a property bubble, the Fed’s predicament becomes all the more intractable. That’s because the monetization of wealth created by property appreciation can only be extracted by debt. While that debt may seem affordable at low interest rates, it becomes exceedingly onerous at higher interest rates. With record levels of household sector indebtedness now pushing toward 90% of GDP, debt-service ratios already near historical highs, and ever-frothy housing markets drawing extraordinary support from rock-bottom interest rates, the perils of aggressive Fed tightening are plainly evident: Rate hikes could well mean game over for the income-constrained, saving-short, asset-dependent, overly indebted American consumer. If that’s correct, the Fed and the BOJ may both be in the same predicament -- unable to extricate themselves from bubble-induced low real interest rate quagmires.
In that context, it is important to stress that a so-called soft patch is a very different development for a post-bubble economy than it is for a more normal one. In a fully functioning economy, the downside of a temporary disruption is normally offset by organic growth in wage income or, in more dire circumstances, by monetary and/or fiscal stimulus. In today’s dysfunctional post-bubble economy, those options are not feasible. For starters, the private sector wage-income generating capacity of the US economy remains woefully deficient -- only about a 5% cumulative increase (in real terms) 40 months into this recovery versus 15% gains, on average, over comparable periods in the preceding five cycles. In part because of globalization but also because of bubble-induced hiring excesses of the late 1990s, cash-rich US companies remain reluctant to step up on both the employment and real wage fronts. Moreover, the combination of large budget deficits and zero real short-term interest rates all but rules out further policy stimulus at this juncture. Normally, overcoming a soft patch is no big deal for an inherently resilient macro system. But for a post-bubble US economy that is out of policy stimulus, it may be a different matter altogether.
The energy-shock scenario provides an alternative perspective. Just as the lagged effects of rising energy product prices have had an adverse impact on consumer and business spending, the mean reversion of falling energy prices is widely viewed as the functional equivalent of a tax cut that will spark a rebound in the economy. With oil prices now slipping beneath the all-important $50 threshold rather than lurching through the $60 threshold as feared just a few weeks ago, the soft-patch crowd sees falling energy prices as a distinct positive to US growth prospects in the second half of this year. In my view, however, it is entirely premature to bank on such an impetus. First of all, the case for sustained relief in energy prices is arguable -- especially in light of ongoing rapid demand growth from China and little near-term relief from the inelastic supply side of the oil equation. Secondly, persistent deficiencies in the economy’s organic wage income generating capacity point to limited macro traction in the event of all but the most precipitous declines in oil prices.
There is another reason to be wary of the energy-price-induced soft patch scenario -- the distinct possibility that any such impetus may well be undermined by the “payback effect” from the massive anti-deflationary policy stimulus of 2003. The playbook on post-bubble policy defense left US authorities with little choice other than to move aggressively toward policy stimulus in response to the deflation scare in the spring of 2003. While those measures were successful in sparking a meaningful reacceleration in the US economy, their impacts now appear to have run out of steam. That’s especially the case for long-lived items such as consumer durable goods (i.e., motor vehicles) and for business spending on capital equipment and software. History and analytics have long told us that rapid growth in both of these “lumpy,” or big-ticket, spending categories almost always borrows from gains in the near future. That’s very much an outgrowth of what economists call a classic “stock adjustment” effect -- a reduction in the flow of new demand when the stock shoots above its desired level.
Recent trends in US economic growth underscore the likelihood of just such a payback. Over the 2Q03 through 4Q04 period, when real GDP was surging at a 4.5% average annual rate, fully 1.8 percentage points, or 41%, of that growth came from combined increases in consumer durables and business spending on capital equipment and software. That contribution was well over twice the 18% combined share of these two sectors in the economy. In other words, the biggest spark to the US growth dynamic over this seven-quarter period of surging GDP growth was concentrated in sectors where payback effects are the norm. At work on the upside were aggressive vendor financing campaigns for motor vehicles, along with a year-end 2004 expiration of temporary tax incentives for capital goods. And now it could be payback time, with the downside of stock-adjustment effects undermining the stimulative impacts of falling energy prices. The just-released 1Q05 GDP report certainly hints at this possibility: The combination of consumer durables and business equipment and software spending accounted for just 0.6 percentage point of GDP growth -- less than one-third the contribution made over the prior seven quarters. Given the magnitude of the preceding overshoot, this payback could be just the beginning -- pointing to a headwind that could be long lasting in offsetting the impetus from all but the most extreme oil price collapse. Meanwhile, an inventory back-up accounted for fully 39% of total GDP growth in the period just ended -- an especially ominous sign in a faltering demand climate. The case for an extended soft patch -- or something worse -- can hardly be ruled out
It was a great ride on the US growth front for a while. But post-bubble excesses have only been compounded during this cyclical respite. An unprecedented drawdown of saving and an ominous buildup of debt, in conjunction with a lasting shortfall of organic income generation, solidified the emergence of the Asset Economy. If the US economy were truly healthy, the Fed should target the federal funds rate in the 5% to 5.5% zone. However, with America’s cyclical impetus fading, post-bubble fault lines could deepen -- making it all but impossible for the Fed to normalize real interest rates. Under those circumstances, this week could mark the Fed’s last rate hike of this cycle.
Financial markets are unprepared for this possibility. In an extended soft patch, growth and earnings expectations are at risk -- pointing to downside pressure on equity markets. Moreover, the inflation scare could be over -- pointing to the possibility of another bullish run in the bond market. In the end, the post-bubble endgame always boils down to the central bank. Unfortunately, like the Bank of Japan, America’s Federal Reserve doesn’t have a viable post-bubble exit strategy. Unlike Japan, however, the US has the mother of all current account deficits -- the pivotal excess of an unbalanced world. Watch out for the dollar: If US real interest rates don’t rise, rebalancing should swing to the currency axis and push the greenback sharply lower. Such are the perils of the post-bubble trap. |
