Why Stephen Roach doubts the IMF's optimism

It was inevitable. Everyone has gone global. And now it's Rosy Scenario's turn that ever-voluptuous step-child of the 1980s who personified the wide-eyed optimism of America's Reagan Administration. In its bi-annual update on the state of the world economy and its prospects, the International Monetary Fund has come up with a baseline view of the world over 2007-08 that would make even Rosy blush.

The latest IMF prognosis is the single most optimistic official forecast I have ever seen for the global economy. After four years of 4.9% average growth in world GDP over the 2003-06 interval, the IMF is projecting two more years of the same average gains of 4.9% over the 2007-08 period. At first, I thought the "num lock" was stuck on the IMF computer. Then I pored through the numbers, read most of the accompanying text, and quickly came to the realization they were dead serious.

IMF growth forecast: key projections

How optimistic is this forecast? The IMF has calculated its official estimates of world GDP as measured on a purchasing power parity basis back to 1970. Over this 37-year history, there is only one four-year growth spurt that is stronger than that of 2003-06 the 5.4% average annual growth outcome for 1970-73. Unlike the current IMF forecast, which calls for another two years of boom-like conditions, the four-year growth surge of the early 1970s was followed by a sharp recession in the global economy, with average gains of just 2.3% over the 1974-75 period. In the modern post-1970 history of the global economy, there has never been a six-year run along the lines of the 4.9% surge the IMF is currently forecasting through 2008.

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That doesn't mean it can't happen, of course. Our own baseline forecast at Morgan Stanley average world GDP growth of 4.5% over the 2007-8 period is not all that different from the latest IMF prognosis. The biggest discrepancy is in Developing Asia especially China, which has a 15% weight in the IMF's PPP-based metric for world GDP. The IMF is currently calling for Chinese economic growth to average 9.7% over the 2007-08 period and that is 0.8 percentage point faster than our 8.9% forecast. The IMF is also slightly more optimistic on India another 6% of world GDP by their metric with a forecast of 8.1% average growth for 2007-08 versus our estimate of 7.6% growth over the same period.

Finally, the IMF is a tad more optimistic on the US (2.2% vs. 2.0% in 2007) and Latin America (4.9% vs. 4.5%). Other than these differences, we're both in the same ballpark.

After 35 years in the forecasting business, I've learned not to take the precision of the exercise too seriously. The value of the baseline forecast is less in the detail of the spreadsheet and more in the directional tilt of the expected growth trajectory. On that basis, there is no mistaking the message from the IMF: They are looking for the strongest global boom in 35 years to be followed by yet another two years of comparable boom-like conditions an unprecedented development for the modern-day global economy. This is the global version of Rosy Scenario.

IMF growth forecasts: key risks to global economy

And that's where I draw the line largely for two reasons: First, I am much more worried about the downside to the US economy than either the IMF or our own US team at Morgan Stanley. In my view, the odds of a spillover from the housing recession to consumer spending are high and rising. I concede it hasn't happened yet but remain convinced that it's only a matter of time in a post-housing-bubble climate before the asset-dependent, income-short, overly-indebted, saving-short US consumer pulls back. The scenario I have in mind envisions US consumption growth, which is currently running at a 3.2% clip year over year, slowing to around 2% over the next year enough of a deceleration to push US GDP growth from its current 2% clip down toward 1% over the same period. Should the US economy follow this type of trajectory, I have little doubt that the rest of the world will be quick to follow. As I have long noted, I am not a buyer of the so-called global decoupling story (see my latest missive on this, "Spillovers versus Linkages," 9 April).

My second concern pertains to the heightened risks of trade protectionism that are currently being manifested in the form of growing frictions between the US and China. I remain convinced that the odds are quite high probably around 60% at this point that a bipartisan, WTO-compliant currency or trade bill will pass both houses in the US Congress with a veto-proof margin by the end of this year. This bill will impose far more stringent sanctions on China either in the form of more broadly based countervailing duties or anti-dumping remedies than the recent actions initiated on paper products and intellectual property rights.

The possibility of Chinese retaliation to such legislation needs to be taken quite seriously retaliation that could take the form of restricting US fixed or portfolio investments into China or even reallocating a portion of the new flow of FX reserve accumulation away from China's historical pattern of dollar-denominated buying. In the latter instance, dollar and US real interest rate outcomes could be far more severe than those assumed in the IMF baseline with far more worrisome consequences for the global economy and world financial markets than suggested by Rosy Scenario.

Interestingly enough, if you take the time to read the latest World Economic Outlook of the IMF, both of these risks are given center stage in the analytical chapters that accompany their baseline forecast.

There is a 40-page chapter on global decoupling and an equally extensive effort on the tensions between capital and labor that lie at the heart of the globalization and protectionism debate. In many respects, these efforts are music to my ears. The framework laid out in both of these chapters is very similar to the analysis I have been presenting for quite some time. The difference is in how far the IMF is willing to push the very concerns they highlight. On global decoupling, they concede a US spillover from housing to consumption would take a serious toll on the global economy; in the end, however, they side with the "containment crowd" that consumers will remain largely unflinching. On the globalization debate, they document in great detail the declining share of labor income in the developed world down some 8 percentage points of developed world GDP since the early 1980s. They simply don't believe that this will have actionable consequences in the political arena a conclusion that is understandable for the world's official stewards of globalization but one that I very much reject on the basis of my recent experience in Washington (see, for example, my 30 March dispatch, "The Ghost of Reed Smoot").

Financial markets are currently discounting something quite close to the IMF's baseline scenario. Should either of the IMF's concerns come to pass possibilities that worry me a good deal most major asset classes could be hit quite hard. In the end, I think the biggest disservice done by the IMF's global prognosis is in the conclusions on risk assessment. Ironically, after having gone to great lengths to document the major risks and concerns in the global economy, the IMF then dismisses the very analytics it so carefully develops. In their own words, the "Risks to global growth now seem more balanced than six months ago." The siren song of Rosy Scenario has never seemed more seductive.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum