Is the global economy really on the mend?
'It seems like eternity since I was last optimistic on the world economy,' says the famously bearish Morgan Stanley economist Stephen Roach. But now he believes the world has turned a corner and the outlook is brightening. So is he right to be upbeat? Or is the conversion of this most bearish of commentators a warning sign for the rest of us?
The famously bearish Morgan Stanley economist Stephen Roach now believes the world has turned a corner and the outlook is brightening. So why the change of heart? And is he right to be upbeat? Or is the conversion of this most bearish of commentators a warning sign for the rest of us? Make up your own mind by reading his latest thoughts on the global economy below...
It seems like eternity since I was last optimistic on the world economy. It was back in 1999 when I argued that "Global Healing" would allow the world to make a stunning comeback from the ravages of the worst financial crisis in 60 years. My enthusiasm was short-lived, however, as the cure led to the mother of all liquidity cycles, multiple asset bubbles, and an unprecedented build-up of global imbalances. While an unbalanced world has yet to shake its hangover from global healing, I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages.
Global imbalances: central banks learn the lessons of the Asian crisis
The reason: the world is finally taking its medicine or at least considering the possibility of doing so. Central banks are carefully adjusting the liquidity spigot taking advantage of the luxury of low inflation to move very slowly in doing so. This delicate normalisation procedure is necessary to prevent wrenching financial market crashes that would spell curtains for an asset-dependent world.
Meanwhile, the stewards of globalisation especially the G-7 and the IMF have finally come to grips with the imperatives of facing up to the perils of global imbalances. They are now hard at work in developing a multilateral solution to a multi-economy problem.
At the same time, orderly currency adjustments appear to have resumed and this time, in the right direction. Ever so slowly, the dollar is being managed lower in keeping with the relative price shift that a long-overdue US current account adjustment needs. As always, there are still plenty of serious risks especially oil, geopolitics, fiscal paralysis, and protectionism. But the world now appears to be getting its act together, and that encourages me.
Central banks remain leading actors in this drama. They almost blew it especially the monetary authorities in Japan and the US. By condoning asset bubbles and their concomitant distortions of debt cycles and increasingly asset-dependent real economies, both the BOJ and the Fed flirted with the most corrosive of macro diseases deflation.
Japan actually succumbed to a mild, yet protracted, strain of this ailment, while the US had a close brush in 2003. The Fed studied the lessons of the Japanese experience carefully and made every effort to avoid a similar fate for the US (see A. G. Ahearne et al., "Preventing Deflation: Lessons From Japan's Experience in the 1990s," Federal Reserve International Discussion Paper, June 2002). While Japan finally seems to be exiting from its long slump, the jury is still out in America, as one bubble (equities) has morphed into another (housing).
Central banks have been aided in their post-bubble tactics by an unexpected ally a persistent disinflation. Courtesy of a rapidly spreading globalisation of both tradable manufactured activity and once nontradable services, powerful structural headwinds have dampened inflationary pressures that might have normally arisen from a cyclical recovery in the world economy. This has provided monetary authorities with the luxury of moving slowly in weaning economies from their post-bubble medicine.
Had inflation responded more to the traditional pressures of the closed economy namely, domestic unemployment rates and capacity utilisation rates monetary policy would have been forced into a more activist post-bubble tightening mode. Instead, the ongoing disinflation of increasingly open economies has transformed the role of central banks.
Rather than playing the destabilising function of leaning against the inflation cycle, the authorities have been given license to focus more on a goal of "normalisation" seeking to put policy rates on a neutral setting that is neither too tight nor too easy. This has reduced the possibility that the world will be disrupted by the boom-bust cycles that frequently plagued the economy of yesteryear.
This is a delicate operation, to say the least. We are in the midst of what could well be the mother of all liquidity cycles. Courtesy of an extraordinary monetary accommodation, financial markets have enjoyed open-ended support from central banks. This has been a key role reversal for the tough guys who are supposed to take away the "punch bowl" just when the party gets good.
Given the power of this liquidity cycle evidenced not just by asset bubbles in major markets but also by an extraordinary compression of spreads on risky assets such as emerging-market debt and more traditional credit instruments a serious monetary tightening could prove devastating for financial markets and increasingly wealth-dependent economies. As long as inflation remains low, however, the authorities can set their sights on the more benign target of neutrality.
The latest downside surprise on the US inflation front another weaker-than-expected increase in the all-important Employment Cost Index provides support for that strategy. Despite a tightening labor market, compensation growth for civilian workers slowed to just 2.8% in the 12 months ending March 2006 down one full percentage point from the pace two years ago. This is yet another example of the power of the global labor arbitrage and good reason to believe that central banks can stay focused on the goal of normalisation rather than tightening.
Global imbalances: on the road to normalisation
The good news is that all of the world's major central banks are now on the road to normalisation. America's Fed is furthest along in this process, and is now sending signals that this interim goal may be in sight. The ECB is not that far behind; since it was not forced into an emergency bubble-defense drill, it does not have that far to go to take its policy stance to a neutral setting even though it has only tightened twice in the past five months. The Bank of Japan is now very much into the normalisation drill; its latest upgrade of the economic outlook has promoted our BOJ watchers to put a 90% probability on a rate hike in either June or July. Even the People's Bank of China has joined the ranks with its first rate hike in a year and a half; in my view, this is likely to be the first of several steps Chinese authorities will take in order to rein in the excesses of their liquidity cycle.
In all of these cases the US, Europe, Japan, and China inflationary pressures remain well contained. That allows central banks in each of these economies to follow the Fed's template of "measured" normalisation balancing the limited risks of inflation against the more serious risks of a major about-face to liquidity cycles. The authorities are, in effect, taking a calculated pro-growth risk for an asset-dependent global economy.
Against this backdrop, the recent breakthrough in long-dormant efforts to reform the international financial architecture is especially encouraging. Don't get me wrong I am still very concerned about the mounting pressures of unprecedented global imbalances. America's massive current account deficit hitting an annualised $900 billion in late 2005 puts an extraordinary financing burden on the world. Moreover, with the three largest surplus nations Japan, Germany, and China all hard at work in stimulating internal demand, America is likely to have less surplus foreign saving at its disposal. With the perils of a US current account adjustment mounting, global authorities had seemed asleep at the switch.
That is no longer the case. I am pleased that they have risen to the occasion not just by devoting a special annex of the recent G-7 communiqu to global imbalances, but also by empowering the IMF to expand its purview to multilateral surveillance and consultations. That finally puts teeth into the global rebalancing campaign. While that doesn't eliminate the possibility of a disruptive US current account adjustment, it does mean that an unbalanced world is now taking its collective responsibility more seriously.
Global imbalances: rebalancing the global economy
The wheels of global adjustment turn very slowly. But at least they do appear to be turning. The dollar is moving lower again after a 15-month hiatus from a multi-year decline that began in early 2002. Like Stephen Li Jen, I am not a believer that a weaker dollar is the cure for global imbalances. But I certainly don't buy the new-paradigm rhetoric of a newly symbiotic world that is built on a foundation of ever-mounting imbalances and a strengthening dollar.
By contrast, I view dollar depreciation as part of the solution for America's excess consumption problem. Another important part of that solution is the end of the US housing bubble and the wealth-dependent excesses of consumer demand this bubble has supported. For that reason, I am also encouraged that the froth now seems to be coming out of the US housing market; recent blips in the monthly data on home sales run against this conclusion, but the trend has been decidedly lower since last summer. Moreover, the latest data on the Employment Cost Index underscores a persistent deficiency on the labor income side of the equation.
Consequently, as the wealth effects from asset bubbles fade, I continue to believe that pressures will build on income-short American consumers setting in motion the only realistic fix to America's gaping current account deficit.
Finally, I am encouraged by what I see elsewhere in the world. I have just returned from my second trip to Asia in the past month, and I sense a major change in the region's global perspective. That's especially the case in China, where the need to stimulate internal consumption has gained great traction in policy circles. If China pulls this feat off, it would do so considerably earlier in its development than Japan, Korea, and other Asian economies.
This only underscores China's amazing capacity to leapfrog everything we know about economic development. Export-led Asia is finally coming to grips with the need to diversify its sources of growth. Given the likely consolidation of US consumer demand long the region's most important customer that's certainly a good thing. A rebalancing of the Asian growth model is a big plus for an unbalanced world.
As I put all these pieces together, I now believe that the odds are shifting away from a disruptive global rebalancing. That tempers my long-standing concerns over the possibility of a sharp decline in the US dollar and a major back-up in real long-term US interest rates that such a currency crisis might have triggered.
Lest I be accused of succumbing to the ravages of terminal jet leg, I assure you that I am still mindful of the ever-present risks that beset a very fragile world. Oil prices above $70 are especially worrisome for the world's oil consumers. The income- and saving-short American consumer concerns me most in that regard especially as the wealth effects from the US housing bubble now start to fade. The mounting geopolitical risks associated with the "Iran problem" all too reminiscent of the build-up before the Iraq War only compound my fears that oil-related disruptions of the world economy are here to stay.
Nor do I dismiss the politically-induced backlash to globalisation that has raised the distinct possibility of an outbreak of protectionism; Washington-led China bashing remains the biggest risk in that regard. And speaking of Washington, the US is rapidly becoming the global poster child for fiscal irresponsibility not exactly a constructive development for the world's biggest borrower.
No, I am not prepared to give an unbalanced world the green light. But it's time to give credit where credit is due: First, to globalisation for holding down inflation. Second, to central banks for collectively embarking on policy normalisation campaigns. Third, to the stewards of globalisation for facing up to the imperatives of architectural reform. And fourth, to Asia especially China for recognising the unsustainability of export-led growth models.
Notwithstanding the risks noted above all of which need to be taken very seriously I am delighted that the global economy finally seems to be taking its medicine. Let's hope the cure works.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum