Resilience in a Vulnerable World

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Notwithstanding the tragedy of London, there can be no mistaking the apparent resilience of the global economy and world financial markets in the face of such adversity. The free world seems more determined than ever to cope with such visible manifestations of the soft underbelly of globalization. We need to be careful, however, in confusing post-attack resilience with an all-clear signal for the global economy. With oil prices at $60, current account imbalances in uncharted territory, and protectionist risks mounting, a precarious world still has plenty on its plate. Moreover, with equity-market volatility remaining at rock-bottom levels and spreads in fixed income markets still extraordinarily tight, an eerie state of complacency pervades world financial markets. It would be foolish to minimize the potential consequences of this mismatch between event risk and a complacent, yet still unbalanced world.

It's tempting to conclude that terrorism has now become a way of life -- and that we have now learned to live with it. Hopefully, at least the first part of that statement will never be the case. Yet the coping mechanism of the global economy and world financial markets in dealing with such shocks looks increasingly robust. That the shocks, themselves, seem to have diminished in the nearly four years since 9/11 certainly tempers the "fear factor" that might have otherwise been associated with successive blows. This may well be an important sign of success in the war against terrorism. That's not to diminish the ever-present risk of a new setback or the increasingly burdensome sunk costs of anti-terrorist efforts -- government-sponsored homeland security programs, increased defense outlays, and private business spending on perimeter and internal security. But there appears to be less "sand in the gears" of globalization than many of us thought might have been the case in a post-9/11 world.

Shocks, of course, are only one part of the global macro story. Even more important, in my view, is the inherent stability of the underlying economy itself. Borrowing from physics, it seems safe to surmise that a shock that hits a stable system is likely to have less of a serious impact than a shock that hits an unstable system. Such are the mounting perils of today's increasingly unbalanced global economy. Over the past four years, our calculations suggest that the disparity between the world's current account deficits and surpluses has widened from 3% of global GDP to a record 4%. Over the same period, the underpinnings of the American consumer -- by far, the most powerful engine on the demand side of the global economy -- have drawn increased support from the wealth effects of overvalued property markets. Complete with a record surge of household sector indebtedness spawned by this equity extraction, the emergence of America's second major asset bubble in five years hardly speaks of inherent resilience in the US or in a US-centric global economy.

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The consensus sees it differently with respect to the US consumer, maintaining that domestic demand is now drawing increasingly solid support from improving labor market conditions and a concomitant pickup in organic labor income generation. Yet another disappointing monthly employment report draws that interpretation into question, in my view. The shortfall of payroll-based job creation in June (+146,000 versus consensus estimates of around +200,000) was all the more disturbing in the immediate aftermath of a weak May report (an upwardly revised increase of only 104,000). This is hardly anything new for the weakest hiring recovery on record. Over the entire 43 months of this economic recovery, private nonfarm payrolls have increased only 2% -- far short of the 11.5% increase recorded, on average, over comparable periods of the preceding five business cycles. At the same time, the hourly wage rate held at its 2.7% y-o-y trajectory -- slightly less than the CPI-based inflation rate and fractionally below the level recorded at the trough of the last recession in November 2001. This does little to correct the serious and highly unusual mismatch between vigorous productivity growth and persistently weak trends in worker rewards. According to our estimates, total hourly compensation in the nonfarm business sector increased only 7.5% in real terms in the first 13 quarters of this recovery (ending 1Q05) -- far short of the 13.0% cumulative gain in productivity over this same interval (see my 7 July dispatch, "Back to the Drawing Board"). Contrary to the post-release spin on the June employment report, the vulnerabilities of the income- and saving-short, wealth- and debt-dependent American consumer remain very much intact.

Against this backdrop, terrorism is hardly the only shock we need to worry about -- external blows constantly bombard the world economy. $60 oil is a case in point. Here, as well, the consensus has all but dismissed the macro implications of this outsize run-up. After all, with warnings at $40 and $50 failing to pan out, goes the argument, why worry at $60? We economists are, of course, trained to make the distinction between oil shocks arising from developments on the demand side of the economy (the "good shock") and those arising from constraints on the supply side (the "bad shock"). With the doubling of the nominal oil price from $30 to $60 over the 2003 to 2005 interval occurring in a period of accelerating global growth, many have excused this shock as nothing more than a benign consequence of a vigorous growth climate. Try telling that to income-short American consumers who are experiencing a sharp deterioration in relative prices that is putting unmistakable pressure on discretionary income and spending. Try also telling that to Asia -- the world's biggest energy guzzler in terms of oil consumption per unit of GDP. I don't think it's a coincidence that many Asian economies now appear to be slowing sharply in the aftermath of this latest upsurge in oil prices -- especially Korea, Thailand, the Philippines, and, to a lesser extent, Taiwan. Moreover, should a China slowdown emerge, as I suspect it will over the next 9-12 months, the risk of a major shortfall in pan-regional Asian growth -- the fastest growing and largest region in the world -- can hardly be ruled out. For a world economy lacking in major offsets to an Asian growth shock, a hit on 35% of world GDP would represent a serious blow to this global expansion.

Nor can the risk of geopolitical shocks be minimized as the odds of protectionism continue to mount. US-China trade frictions remain most worrisome in that regard. On the surface, Washington seems to be turning down the heat, as the Senate co-sponsors of the China Currency Bill (Charles Schumer (D-NY) and Lindsey Graham (R-SC)) recently elected to defer a floor vote on their measure until the fall. There's more to this maneuver than meets the eye. I actually think this latest development ups the ante on the high-stakes China-bashing front. If China has not changed its currency policy by October 15 -- a distinct possibility, in my view, especially in the context of a slowdown in the Chinese economy -- then the US Treasury most likely will re-classify the nation as being formally guilty of "currency manipulation." At that point, Senate passage of anti-China trade legislation will be much easier to achieve. And the world could then begin to slide quickly down the slippery slope of trade frictions and protectionism. For an unbalanced and vulnerable global economy, the economic impacts of this shock would be every bit as worrisome as another outbreak of terrorism. As Harvard President and former US Treasury Secretary Larry Summers has stressed, capital inflows are the financial and economic equivalent of "weapons of mass destruction" (see his 2004 Per Jacobsson Lecture, "The US Current Account Deficit and the Global Economy" October 3, 2004). I couldn't agree more. Should the US, with its massive current-account deficit, lose external funding support for any reason, the ensuing pressures on the dollar and interest rates could deal an especially lethal blow to America's asset- and debt-dependent economy. The rest of a US-centric world would then quickly be in trouble as well.

Terrorist attacks are a grim reminder of our personal vulnerability to outrageous acts of carnage and destruction. They put the dark side of globalization in its worst possible light. The world lost its innocence nearly four years ago on September 11, 2001. The good news is that the global power structure has risen to the occasion in limiting the severity of subsequent actions. Equally encouraging is a resilient global economy's capacity to ward off the impacts of such blows. But this resilience needs to be set in context. Today's unbalanced world is in many respects more precarious than it was four years ago. That leaves it more vulnerable to the ever-present shocks that always seem to afflict the macroclimate. The confluence of three such shocks -- terrorism, oil, and protectionism -- can hardly be taken lightly in the current climate. Add in a China slowdown and the downside of an ever-precarious US property bubble, and the very notion of inherent resilience of the global economy can be drawn into serious question.

We need to be very careful is drawing a false sense of economic security from post-attack resilience to terrorist strikes. The impacts of any such rebound may prove fleeting -- especially for financial markets, where most of the risk has now been priced out of risky assets. Should any shock -- terrorism, oil, protectionism, a China slowdown, or a bursting of the US property bubble -- produce a meaningful shortfall to global growth, equities would undoubtedly sag and sovereign bonds most likely would rally further. The benefits of warding off the blows of terrorism may ring increasingly hollow in an unbalanced and vulnerable world.

By Stephen Roach, Morgan Stanley Economist, as published on The Global Economic Forum