We are all creatures of habit. That's true of economists, investors, policy makers, and politicians all of whom look to signs from the past as guides to the future. That leaves us captives of history, whether we like it or not. I have great respect for history and spend a lot of my time reading it. But I have long been struck by the flaws of autoregressive thinking extrapolating on the basis of recent trends and looking for guidance from historical patterns to predict the future. Time and again, we learn that no two cyclical endgames are alike. Yet time and again, we draw the wrong inferences from patterns of earlier periods. This is one of those times.
Why the economic cycle is different this time
On one level, the world is in the midst of a very benign cyclical climate. At work is a remarkably constructive inflation climate. Absent the normal tendency of a cyclical upsurge in inflation, there appears to be no need for central banks to take the proverbial punchbowl away to borrow from the imagery of former Fed Chairman William McChesney Martin. A lot has been made about the recent updrift in core inflation hitting 2.9% for America's core CPI, 2% in the Euro-zone, and a fractionally positive reading in a long deflationary Japanese economy. But let's face it, by standards of the past 35 years, these are excellent outcomes. In that context, the "normalization" response of central banks is a far more tolerable course of action than the wrenching monetary tightenings that have wreaked such havoc on cycles of the past. Awash in liquidity, financial market participants have no compunction about putting more and more money to work. Absent the primary peril of past cycles, goes the argument, there seems to be little to fear in the current cycle.
Yet this time is different. Sure, that's the classic "ah ha!" code words for ever-cynical investors to ignore anything that follows. But it's important to understand the corollary of this reaction namely that nothing ever changes. That's where I have a serious problem. Consider globalization the most important mega-force of our lifetime. This is the first time that the powerful disinflationary forces of globalization have had a major impact on the endgame of a modern-day business cycle. Consider IT-enabled technological change; this is the first time that revolutionary breakthroughs in connectivity, miniaturization, and software programming have shaped the cyclical endgame. Consider ever-mounting global imbalances a disparity between current account surpluses and deficits that has reached a record 6% of world GDP. This is the first time that imbalances of this magnitude have threatened the global economy and world financial markets. Consider also the gap between record returns on capital and the sharply depressed rewards of labor in the developed world; it's been a long time since the potential social and political consequences of such tensions were in play. I could go on and on underscoring the unprecedented growth in synthetic securities (i.e., derivatives), the doubling of the global labor supply traceable to the emergence of China, India, and the former Soviet Union, rapidly aging populations in the developed world, unfunded retirement and medical-care liabilities, and surging M&A and LBO activity. The point is that it makes no sense whatsoever to ignore the truly unique features of the current climate. Those who dismiss such possibilities because of the legendary lore of four words "this time is different" do so at great peril, in my view.
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The cyclical endgame is invariably a by-product of the excesses that build up during an expansion. This cycle is no different in that regard it is just distinguished by its own unique strain of excesses. Three such excesses are at the top my list a profusion of asset bubbles, ever-mounting global imbalances, and the growing potential for pro-labor shifts in economic policies. Cyclical history conditions us to look for the proverbial trigger that might take an excess to the breaking point. Interest rate pressures brought about by anti-inflationary monetary tightenings are the classic candidate for such a trigger. The current cycle, with its absence of serious inflationary pressures, seems almost trigger-free in the context of cyclical excesses of the past. Little wonder that liquidity-driven markets continue to rise to ever-higher highs or that traditionally risky assets such as emerging market debt and equities, corporate credit, or mortgage-backed securities continue to be priced for a veritable absence of risk. In a benign inflation climate, there seems to be nothing to fear.
We have nothing to fear but the lack of fear itself
Playing off a famous line from Franklin Delano Roosevelt, former US Treasury Secretary Larry Summers recently quipped, "We have nothing to fear but the lack of fear, itself." I couldn't agree more. Yes, normalization may well be the worst-case outcome for inflation-phobic central banks thereby ruling out the interest rate pressures that have triggered many a cyclical endgame in the past. But that doesn't mean we should conclude that late-cycle excesses pose little or no threat to the current global business cycle.
The bursting of the US housing bubble is an important case in point. Despite a lack of interest rate pressures, there can be no mistaking the abrupt sea-change in America's housing market. This is quite consistent with conclusions of Yale Professor Robert Shiller, who has devoted as much effort as anyone to studying the excesses of speculative activity. Shiller has long argued that asset bubbles don't need to be pricked by a pin that they invariably implode under their own weight. That's pretty much the way the equity bubble burst in 2000, and six and a half years later, such a thesis applies equally well to the demise of America's property bubble. David Miles is making a similar argument with respect to the UK housing market (see his 22 November 2006 report, "UK Housing: How Did We Get Here?"). The only questions insofar as the US shakeout is concerned and they are obviously quite important questions pertain to the extent of the post-bubble downside in housing markets and the broader macro impacts of such a development. I am in the camp that believes these post-bubble adjustments are a big deal for the asset-dependent American consumer, as well as for a US-centric global economy that remains overly reliant on the US consumption dynamic as the sustenance for economic growth. I may be wrong on the conclusions, but it is important to stress that it didn't take an interest rate trigger to bring this issue to a head.
Interest rate pressures
Nor does a disruptive rebalancing of an unbalanced world require an interest rate spike to mark it to market. I will concede that I have certainly been wrong in warning of the imminent consequences of America's coming current account adjustment. By now, I am probably the last person in the US who even thinks about such a possibility. But with the dollar now under pressure again amid renewed talk of central bank diversification out of dollar-denominated assets, it's important not to lose sight of the fundamental saving disparities that might allow this adjustment to take on a life of its own. Most investors and currency experts see the trigger of recent developments in foreign exchange markets as a "euro overshoot." That's quite possible, but here as well, let the record show that currency markets are on the move in a relatively benign interest rate climate. The dead weight of America's massive current account deficit may finally be coming into play at just the point when most believe it is not a problem. The long history of currency markets especially the time-honored tendency for a tightly bunched consensus to get it wrong hints at just such a possibility.
A similar conclusion is evident with respect to the potential for pro-labor shifts in economic policies. This could be an outgrowth of mounting concerns over widening disparities in the income distribution. This is a highly contentious issue, with statistical support on both sides of the debate. Here, as well, the experience in the United States is germane to the issue of the cyclical trigger. The issue is especially noteworthy in that America has been largely alone in the developed world in experiencing a significant and sustained surge of productivity growth normally considered a sure-fire recipe for increased labor income. Yet Ian Dew-Becker and Robert Gordon of Northwestern University recently have found that only the top 10% of the US income distribution experienced growth in labor income equal to or above aggregate productivity growth; it follows that for the remaining 90%, gains in real compensation have fallen short of productivity growth (see "Where Did the Productivity Growth Go," Brookings Papers on Economic Activity, 2005). This was a key issue in the recent mid-term elections in the US, providing an important point of traction for pro-labor Democrats in many parts of the country. While it remains to be seen if there are major policy consequences of the ensuing political realignment that might derail financial markets or the real economy, here as well, the macro trigger had nothing to do with interest rates. Nor does the US have a monopoly on the income-distribution debate. Such concerns are also evident in Europe, China, and India.
What would it take to destabilise the markets?
In the absence of interest-rate pressures, most believe that financial markets enjoy a Teflon-like immunity from any and all potential sources of adversity. I have my doubts. A number of potentially powerful macro forces are now in play that could challenge this conclusion namely, a bursting of the US housing bubble, renewed dollar weakness, and a pro-labor swing of the political pendulum. Any one of these developments has the potential to derail a seemingly benign macro climate. A combination of them would be all the more destabilizing.
The risk is that investors are trapped in the past aiming their defenses in the wrong direction. Such a possibility reminds me of the legendary Battle of Singapore in 1942. Convinced that the next war would be like the ones of the past, British military strategists positioned their fixed artillery for a classic invasion by sea. The Japanese, of course, invaded by land from the North leading to what historians have called one of the largest and quickest capitulations in British military history and Winston Churchill's worst disaster. Here's where history may have something to say about increasingly complacent financial markets. No two endgames are alike.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
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