After four years of booming global economic growth, I have argued that the world is due for a rest - not a hard landing but a marked slowdown from the strongest surge since the early 1970s. The verdict in the early days of 2007 is that I could well be wrong. For longer than I care to remember, my base case has argued that ever-mounting imbalances will ultimately crimp vigorous growth in global economy. While there can be no mistaking the imbalances of a US-centric world, there can also be no mistaking the extraordinary resilience of the great global economic growth machine. Is it time for a new approach?
What is the main source of economic growth?
The debate over the sources of growth is as old as the economics profession itself. That debate has great relevance for global rebalancing - especially since it makes the important distinction between growth that is dependent on external or internal sources. In the end, only the latter strain of growth is self-sustaining. That raises one of the toughest problems of all for an unbalanced world: The demand side of the global economy has been dominated by the American consumer, where growth in recent years has been underpinned less and less by the traditional support of income generation and more and more by the wealth effects of an increasingly asset-dependent economy. As the balance shifts from income- to wealth-dependent growth, the risks of financial vulnerability can mount. That's certainly been the case in the United States, with record levels of household sector indebtedness, sharply depressed domestic saving, and massive current account deficits.
Similar sustainability concerns pertain to the supply side of the global economy - increasingly dominated by China. In this case, the growth dynamic has been concentrated in China's two most outward-looking sectors - fixed investment and exports, which collectively account for about 80% of Chinese GDP. The sustainability requirements of such an externally-led growth framework are very different from those of the demand-side model. The investment process has to be rational, with capital allocated in the right dosage to the right industries - avoiding both production bottlenecks and capacity overhangs that might jeopardize ongoing growth. The export process needs to match the needs and aspirations of China trading partners - without creating undue cross-border frictions.
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What imbalances mean for the world economy
My problem with sustainability of the current strain of global growth arises mainly out of the internal imbalances of the US and Chinese economies. In recent years, America's asset-dependent economy has been prone to periodic bubbles - first equities and now property. Post-bubble shakeouts crimp equity extraction from asset markets - putting pressure on income-short consumers to rebuild income-based saving rates. By contrast, China's supply-led model has been funded, in large part, by a relatively undisciplined system of policy-directed bank lending. That underscores the risks of a misallocation of capital that could lead to excess supply and deflation. At the same time, China's export-led dynamic is now eliciting a mounting protectionist backlash from both the US and Europe. With growth risks tipping to the downside in both the US and China, I have argued that slowing is inevitable for a two-engine global economy; lacking in support from private consumer demand, the rest of the world is not nearly as decisive in shaping the global growth outcome.
Globalisation has played a dual role in driving the great global growth machine. It has both real and financial dimensions - with the former reflecting a sharp acceleration in cross-border trade in goods and services and the latter responsible for an even more dramatic increase in cross-border flows of financial capital. Moreover, several of the key implications of globalisation have acted to reinforce the interplay between the income and the asset economy - namely low inflation and low interest rates, as well as the recycling of global saving from surplus to deficit nations. But the implications of globalisation also cut the other way. Key in that regard is a global labour arbitrage that has led to an unprecedented divergence between the returns to capital and the rewards to labour in the industrial world. That has triggered an equally worrisome political backlash that could certainly pose serious risks to financial markets and the asset-dependent growth that increasingly underpins the global economy.
Ultimately, the question of sustainability is an exercise in "equilibrium economics." I have long argued that it's a bit like physics - that an unbalanced economy is akin to a system in disequilibrium that is especially vulnerable to periodic shocks. It follows, in my view, that the further an unbalanced global economy moves away from equilibrium, the greater its rebalancing imperatives. With the gap between current account deficits and surpluses nearing an unprecedented 6% of world GDP in 2005, in recent years I became increasingly concerned about the possibility of a disruptive rebalancing. I was heartened last spring when the stewards of globalisation - namely the G-7 finance ministers and the IMF - finally saw the world through a similar lens and moved to put in place a framework that addressed the imperatives of collective action in coping with mounting global imbalances (see my 1 May 2006 dispatch, "World on the Mend"). While I lowered the odds of a disruptive rebalancing accordingly, I still maintained my earlier view that the risks to global growth remained on the downside.
Will rebalancing mean slower economic growth
A slowing of global growth is, in fact, a key implication of the rebalancing framework. That conclusion is an outgrowth of America's unsustainable consumption binge - the main force behind the extraordinary squeeze on income-based saving and the concomitant widening of massive US current account and trade deficits. Since these imbalances cannot be resolved without a reduction of excess consumption and since the world lacks another dynamic consumer that could fill the void in the event of a consolidation in US consumption, I have increasingly viewed a US-led global rebalancing as recipe for slower growth in world GDP.
That's, of course, exactly what has gotten me into trouble. Far from slowing, an increasingly unbalanced global economy just ended a fourth consecutive year of the strongest growth since the early 1970s. And so it turned out that an increasingly unbalanced world has not been nearly as vulnerable to shocks as I had thought would be the case. Not only did it weather a major oil shock, but the latest data coming out of the US - especially employment and retail sales - suggest the American consumer is hardly being derailed by the bursting of the property bubble.
As always, the jury is still out on the risks associated with global rebalancing. That's especially the case in light of an emerging China slowdown, a mounting protectionist backlash, and the still-to-be-determined extent of post-property-bubble aftershocks in the US. It's certainly possible that any one of those adjustments could suddenly take a turn for the worse and thereby pose a serious risk to an unbalanced and still precarious world. But at least for now, there's little sign of a meaningful slowdown in global growth or any collateral damage such an outcome might pose for financial markets. Our US economists are actually raising their sights on near-term growth prospects - unambiguously good news for externally-dependent economies elsewhere in the world. Similarly, Washington is sending increasingly clear signals that an era of pro-capital policies may be coming to an end, but an earnings-sensitive stock market has hardly flinched. And despite the mounting risks of trade frictions, the US dollar has actually strengthened a bit in early 2007 - once again defying the relative price adjustments of the rebalancing script.
A moment of truth for the global economy
I've been around this track long enough to know when it's game over for a big macro call. I must confess that my patience is definitely wearing thin. All this poses one of the toughest questions for the macro practitioner: Are you wrong if you have the analytical framework correct but the consequences wrong? It has long been said that being early on market calls is the functional equivalent of being wrong. I certainly concede that point with respect to the implications of my basic call. However, with many of the rebalancing tensions I have long been warning of now coming to the surface, I am not willing to concede on the analytics of the global rebalancing framework. I still believe it is a powerful way to understand the forces and risks that drive today's unbalanced, yet increasingly interdependent, global economy.
But that's not enough. We live in a mark-to-market world, and it's not acceptable just to counsel patience in waiting for the big calls to break one way or another. We owe it to ourselves - and, of course, to our loyal followers - to figure out why the consequences don't match up with the analytical conclusions of the framework. My own explanation has long pointed in the direction of the global liquidity cycle - especially the lack of interest rate pressures up and down the risk spectrum. Without a meaningful jolt to interest rates, the asset economy is able to keep cushioning the real economy from otherwise disruptive shocks. It's as if excess liquidity has been the perfect complement to the tensions arising from the globalisation of cross-border production, employment, and trade. Yes, as many have pointed out, excess liquidity has become the all too convenient rationale for all that seems awry in financial markets. This may be one of those times when the crowd is correct.
If so, that conclusion does not bode well for a still unbalanced world. From tulips to dot-com, the cycle of fear and greed has all too often gone to extremes in asset markets. In an era of excess liquidity, asset bubbles are the norm - not the exception. In the past seven years, there has been an equity bubble, a housing bubble, and now a risk bubble. I am not convinced that financial globalisation has progressed to the point where an increasingly asset-dependent global economy is now self-cushioning - essentially immune to the risks of post-bubble adjustments.
Notwithstanding those concerns, the latest batch of data has certainly not broken my way. While that does not convince me I have the basic framework wrong, it certainly puts me on notice that the proverbial moment of truth could well be close at hand. If the great global growth machine doesn't start to slow by the end of this year, it'll be high time to give up the ghost.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
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