The Optimism of a Pessimist

A lot of people are upset with me these days. For the past several years, I have been rather vocal in stressing the mounting risks of an unbalanced world. With that stance comes the inevitable label of the pessimist -- the doomsayer who is increasingly expected to say something bad about everything. When I don't do that -- as exemplified by my recent bullishness on bonds and my more constructive views on Europe -- the response has bordered on shock. Other pessimists feel as if I have turned on them in an almost "treasonous" fashion. Such are the perils of labels. No one -- neither an optimist nor a pessimist -- should be painted with one brush.

My newfound optimism on the bond market is a case a point. My call on US interest rates has long been framed in the context of a classic current account adjustment -- a shift from deficit back toward balance that, for most nations, is invariably accompanied by the combination of a weaker currency and higher real interest rates. I still believe such an endgame eventually awaits the United States -- leaving me an unrepentant bond bear. But I now expect something else to happen first -- namely, a China slowdown brought about by a marked deceleration of growth in its fixed investment and export sectors. With these two sectors collectively accounting for 80% of Chinese GDP and currently growing at a 30% y-o-y rate, a China slowdown arises from the confluence of internal policies aimed at the excesses of China's property bubble and external protectionist pressures taking dead aim on Chinese exports. If I'm right, this will lead to a deceleration of pan-Asian GDP growth and a sharp fall-off in commodity prices -- both bond-bullish developments.

At the same time, I would stress the transitory nature of this constructive conclusion on the bond market. To the extent the China slowdown is but a temporary detour for a high-growth Chinese economy, reductions in interest rates are likely to be relatively short-lived -- perhaps lasting only a year or so. Moreover, during the hiatus of lower interest rates, the asset-dependent American consumer could well take advantage of yet another blow-off in an already bubbly housing market -- leading to another spending binge, ever greater extensions of debt, reduced national saving, and a further widening of the current-account deficit. As China comes out of this cyclical downshift, the US current-account deficit could well re-emerge as the dominant force shaping world financial markets -- possibly with an even sharper adjustment than might have otherwise been the case. That might be reason enough to shift back to a more bearish assessment of the bond market -- albeit from lower levels of longer-term rates than previously thought.

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Unlike my rethinking of the interest rate outlook, there are no strings attached to my newfound optimism on Europe. I continue to feel that the angst over Europe's political disappointments is obscuring the meaningful progress being made on structural reforms. The failure of the EU constitutional referenda in France and Holland, in conjunction with the acrimonious ending to the recent European summit, does not undermine the case for structural change, in my view. Labor market rigidities are improving at the margin -- underscored by progress in Germany, where shortened workweeks are being abolished, labor unions are losing their industry-wide bargaining power, and the rapid growth of part-time and temporary workers is creating a more flexible workforce. Equally encouraging, in my view, is Corporate Europe's recent push into IT-enabled capital spending -- a belated but nevertheless encouraging catch-up to the trend first established by the US in the late 1990s. Finally, it is important to note the flurry of corporate restructuring activity now evident in Old Europe, especially in Germany. What emerges out of all this is an encouraging case for European productivity improvement after a decade of anemic performance. Ironically, the recent political setbacks may serve the unintended, but positive, role of clearing the decks for more heavy lifting on the structural reform front.

If I were to pick one area of the macro landscape where I am more optimistic than most, it would have to be the global inflation prognosis. With a new and increasingly powerful strain of IT-enabled globalization shaping activity in tradables (manufacturing) and nontradables (services), alike, inflation models need to be re-thought. While cost and input pressures can certainly accelerate from time to time -- as they have done recently -- pricing leverage should no longer be thought of in the context of the relatively closed domestic models of yesteryear. It's not surprising, in my view, that US core inflation has remained remarkably low in the past year -- even in the face off rapid GDP growth, accelerating commodity inflation for energy and non-energy items, alike, and some whiffs of slower productivity growth and mounting labor cost pressures. Pricing leverage is much harder to come by in increasingly global product and services markets that remain awash in excess supply.

Here, as well, there is a catch to my optimism. A deceleration of economic growth almost always results in a cyclical disinflation -- a temporary reduction in underlying inflation. The problem arises when that disinflation occurs from a low starting point. The lower the pre-recession rate of inflation, the closer a cyclical disinflation can push the aggregate price level toward outright deflation. That was very much the case with America's deflation scare of mid-2003: The post-bubble recession of 2001 hit a US economy whose core CPI inflation rate was running at only 2.2% at the prior cyclical peak in early 2000. If a recession were to occur today when core inflation is also running at just a 2.2% pace, the resulting cyclical disinflation could well give rise to yet another deflation scare. This underscores an especially dangerous condition for bubble-prone economies: At low levels of CPI inflation, post-bubble shakeouts and deflation scares go hand in hand. That was the case in the aftermath of the equity bubble and could well be the case after the US property bubble bursts.

Labels are unfortunate in this business. I guess they come with the territory. But macro is not just black or white -- there are nuanced dimensions of any scenario. There are many mega-forces at work in today's $44 trillion world economy. Three such forces are at the top of my agenda: the rebalancing of an unbalanced world, the excesses of an asset-dependent American consumer, and the daunting transformation of the Chinese economy. It is always tempting to focus on each of these problems in isolation -- losing sight of the reality that always comes from the confluence of such forces. The pessimist in me stems mainly from my worries about the United States -- especially the potentially deflationary implications of the interplay between a likely current account adjustment and the bursting of yet another asset bubble. The optimist in me -- yes, there is one -- takes comfort from low inflation, the China reform story, and the powerful competitive pressures that emerge from globalization.

The real trick, of course, is to sort out a probabilistic assessment of the pluses and minuses. For me, the glass remains half-empty -- reflecting a balance that is still tipped to the pessimistic side of the macro equation. But there is plenty of room in such a scenario to allow for positive developments -- especially in places such as Europe, China, and India, where the potential for structural change is the greatest. The honest pessimist can most assuredly have an optimistic side.

By Stephen Roach (New YorkMorgan Stanley Economist, on The Global Economic Forum