It never fails. Every presentation or speech I have made on global rebalancing over the past three and a half years always ends with the same question: When will these global adjustments ever occur? This, of course, is a polite way of re-phrasing the toughest critique of the rebalancing call: The history of the last couple of years is littered with false alarms over the coming US current account adjustment. Call it the "boy-cries-wolf syndrome." The longer the world endures mounting imbalances without suffering any serious consequences, the more the financial-market consensus believes this disequilibrium is sustainable.
I can certainly understand the frustration. After all, in investor circles, being early is the same as being wrong. In my view, the outcome underscores one of the greatest shortcomings of macro-economics the ability to identify the tensions of disequilibria but the failure to depict the conditions that lead to the restoration of a new equilibrium.
Of course, there is always the possibility that I've got the framework wrong. That's certainly the implication of the new paradigms of international finance that have sprung up in recent years to explain why the once-unsustainable is now sustainable. That's precisely the inference that can be taken from the leading new theory the so-called Bretton Woods II regime that depicts a newly symbiotic relationship between the US and a China-centric Asia.
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But even if the new paradigms are classic top-of-market rationalizations, there are no guarantees on the timing aspect of the macro adjustment framework that I endorse. In my view, that's largely a call on event-risk in this instance, predicting the exogenous shock that then triggers a loss of confidence in dollar-denominated assets and the long-awaited US current account adjustment.
That's not to say that we macro practitioners should duck the issue. In the back of my mind, I always keep a running list of possible event risks, or shocks, that I believe would be capable of triggering the rebalancing of an unbalanced world. My risk assessment has long been skewed toward US-centric concerns consistent with my belief that just as the US accounts for a disproportionate share of the world's imbalances, it could well be the greatest source for an unwinding of those imbalances. That underscores the asymmetric risks of global rebalancing driven by a US that accounts for 70% of all the current account deficits in the world, while at the same time the incidence of current account surpluses is more widely diffused in a much broader number of economies.
My top candidates for event risk include the following: an outbreak of US protectionism, the bursting of the US housing bubble, a US inflation problem, the end of fiscal discipline, or a financial accident in the US. All of these potential events have one thing in common they would shake the confidence factor that underpins official and private investor appetite for dollar-denominated assets. A weaker dollar and sharply higher US real interest rates are the classic characteristics of a US current account adjustment, which remains central to the rebalancing endgame. In my view, the confidence factor has been the key reason these adjustments have not yet occurred.
The saving-investment framework provides some important hints in handicapping the event risks that could shape the timeframe of global rebalancing. In a US-centric world, it is entirely reasonable to focus on US-centric shocks as the prime candidates to spark global rebalancing.
America's record saving shortfall means that it is heavily reliant on foreign capital inflows to forestall the currency and real interest rate adjustments that might otherwise trigger an abrupt rebalancing. With the US current account deficit running at close to a $790 billion annual rate in the first half of 2005, foreign capital inflows need to average about $3 billion per business day in order to fund America's external shortfall. The only way the US can attract those flows without having to offer currency or real interest rate concessions is to maintain its special allure as the world's leading economy and high-return asset market.
Those perceptions could be challenged by the event risks noted above. For example, if Washington-led China bashing results in the enactment of protectionist tariffs hardly idle conjecture in the aftermath of China's minimal currency adjustment on July 21 the Chinese monetary authorities could certainly curtail their seemingly open-ended purchases of US Treasuries. With diminished capital inflows from China, that would make it much harder for the US to finesse its glaring saving-investment gap. Similarly, a bursting of the US housing bubble would undoubtedly lead to a sharp retrenchment by the American consumer drastically altering the growth expectations that underpin the "confidence factor." Related to any post-bubble shakeout would also be the increased likelihood of a financial accident brought about by the unwinding of the property-driven debt overhang.
The same could be said of an upside surprise to US inflation an outcome that could shake both domestic and foreign investor confidence in dollar-denominated assets. At the same time, a fundamental erosion in US fiscal discipline clearly a possibility in the aftermath of Washington's rush to embrace post-Katrina spending initiatives raises similar questions about America's ability to finance its investment-spending gap. With an anemic private saving rate, larger federal deficits would lower overall national saving forcing the current-account deficit to widen further. Moreover, to the extent overseas investors had come to believe in the decade-old mantra that the end of big government was at hand, foreign confidence in dollar-denominated assets would undoubtedly suffer further.
But there are important offshore possibilities that might also prove challenging for global rebalancing as seen through the saving-investment framework. An additional energy shock is an obvious candidate that could put pressure on all major components of US saving personal, government, and business; the further widening of the US current account deficit that would arise from such a jolt could well be a tipping point for rebalancing.
Another externally-driven possibility would be a reduction of surplus saving in the non-US world. A nascent economic recovery in Japan could well reduce the world's largest current account surplus leaving less for Japan to invest in US Treasuries and other dollar-denominated assets. The same could be the case in Germany if recovery ever takes hold there, as well. Similarly, were China to reduce its ever-widening current account surplus precisely the endgame that protectionist politicians in the US and Europe are seeking that would also limit the pool of excess foreign capital that a saving-short US economy so desperately needs.
A new wrinkle in this aspect of the equation is the lack of a decisive vote for change in the just-completed German national elections. In my opinion, the failure of Angela Merkel to win a clear-cut victory underscores the surprisingly lukewarm commitment of the German body politic to change in the world's third-largest economy. While this outcome is unlikely to have an immediate impact on the German economic recovery or its current-account surplus, it could well undermine investor confidence in the likelihood of an accelerated pace of European reforms punishing the euro and thereby boosting confidence in dollar-denominated assets. At the same time, if political aftershocks from the mid-September election dampen longer-term prospects for German recovery, that would tend to put the onus of rebalancing more on the back of the US undermining the more optimistic case for a broader realignment of an unbalanced world.
I fully realise this is not a satisfactory explanation for trigger-happy investors those who want a specific event and a date that defines the rebalancing trigger. Yet this is the best we in the macro business can do laying out a framework that depicts the tensions that arise from disequilibria, and then narrowing down the possibilities of what might spark a return to a more sustainable equilibrium.
The bottom line for me is that the tensions are building quite possibly at an alarming pace. The prospects for America's already bleak savings outlook are deteriorating at precisely the point when the outlook for surplus overseas saving is starting to deteriorate as well. This puts an unbalanced world increasingly on a collision course with the pyrotechnics of a US current account adjustment. That underscores the mounting risks of a disruptive endgame very much at odds with the gradual adjustments of the benign endgame that most still believe is likely. Sadly, such a risk assessment has been evident from the start.
In the end, the history of crisis management is clear on one thing: The longer any economy holds off in facing up to its imbalances, the greater the possibility of a hard landing. In my view, an unbalanced world has waited far too long to face up to the heavy lifting of global rebalancing. I would now assign about a 40% probability to a hard landing at some point in the next 12 to 18 months that shows up in the form of a sharp decline in the dollar and/or a sharp increase in real US long-term interest rates.
By Stephen Roach, Morgan Stanley economist, as published on the Global Economic Forum
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